May 23, 2023
## Payment flows in construction

For the last week I was working with a founder team in the construction cash flow space. It triggered me to look deeper into the payables, receivables and cash disbursement workflows in the construction industry in the US and UK markets.

Last month I had first referred to a guesstimate that up to 55 billion invoices might be issued every year across construction markets.

Working with the abovementioned founder team, I dug deeper into this number and had wanted to cross-check and substantiate it further.

**I’ll work the number per project through a rough top-down estimate:**

- Let’s assume an average construction project runs for 15 months
- Builders use an average of 22 sub-contractors per project
- As for material supply invoices, I was unable to find a good source. So I’ll have to run with a total guesstimate here – let’s say each sub-contractor makes 20 distinct materials purchase orders (POs), and each general contractor makes 200 materials POs. Let’s further assume each PO leads to 2 partial incoming invoices from materials suppliers. That gives 22x20x2 + 200×2 = 1’280 incoming materials invoices for an average project. Let’s round it to 1’300.
- Now, let’s go to the contracting invoices themselves. We have an educated guess that each sub-contractors works for ca. 3 months. That makes 4.4 sub-contractor equivalents over 15 months project (22 / 15 x 3 = 4.4)
- Let’s assume that the subs as well as the general contractor write outgoing invoices (or applications for payment, for that matter) twice per month per project. That gives (4.4 + 1) x 2 x 15 = 162 outgoing invoices upstream. Let’s round it to 200.
- So overall, on an average 15 month project, we could be looking at 1’500+ invoices and money transfers.
- Now: because each invoice creates a payable and a receivable, and requires them to be closed after cash is received we actually look at 6’000+ book entries per project.

**Now let’s extrapolate to the number of construction projects:**

- The US issues ca. 1.4M building permits for residential buildings per year. Not all permits lead to construction. In Western markets, an educated rule of thumb is that 25% of permits remain unused. This gives 1’050’000 residential new-build projects in the US per year. Let’s round down to 1M.
- The US makes up ca. one seventh of the global construction market.
- Which means, there could be 7M residential construction projects worldwide per year.
- Now, historically, residential is ca. 33% of all construction spending. The other 67% are performed across commercial, industrial and infrastructure projects. Because those projects carry significantly larger sizes, there should be proportionally less projects in those segments.
- Let’s assume non-residential projects carry 10x larger spending per project. That means there could be 7M / 10 x 2 = 1.4M non-residential construction projects per year globally. Again, let’s round down to 1M.
- In total, that would give 8M construction projects worldwide p.a.. (Broken down to the US, for example, that would be ca. 1.2M projects per year – sounds directionally right)

The 1’500 invoices and 6’000 book entries mentioned above happen over a 15 months timeline. We need to scale them down to 12 months:

- Invoices:
- 1’500 / 15 x 12 = 1’200 per year per project
- x 8M projects worldwide
**= 9.6 billion invoices p.a. worldwide in construction (let’s round up to 10 billion)**- The truth is likely somewhere in-between these 10B and the 55B.

- 4’800 book entries per year per project
**= ca. 40 billion book entries p.a. globally in construction**(and could be as much as 200B)

That’s a lot of cash flows and paper. **Here’s a few big issues with this many invoices and book entries:**

**Massive working capital**. Because the various construction stakeholders are traditionally financed from within the same supply chain, one party has to front cash to pay the other party. Incoming and outgoing payments don’t happen on the same day. The difference is the working capital required for construction.**Developers are at constant risk of a general contractor default**. The more sequential invoices from sub to GC to developer, the bigger that risk.- Ugly accounting and treasury overhead
- Error prone

We know that construction is a $10 trillion global market. Let’s say on average, there’s 30 days of working capital in the construction system. That would amount to $10T / 360 x 30 = **$830B of construction working capital.**

To cross-check whether this number sounds directionally right: that would be ca.:

- $830B x 33% / 7M =
**$40K working capital per residential project** - $830B x 67% / 1M =
**$550K working capital for a non-residential project**

While these numbers won’t be accurate, they are in the right ballparks.

Now imagine you could eliminate one pass-through party in the construction invoice chain, and find a way to pay suppliers more directly. Thus you might be able to reduce the invoices and wires by as much as 50%, which would reduce the working capital by proportionate 50%, or as much as $400B globally, $60B in the US or $20K+ on an average residential project.

**To summarize:**

- 10B – 55B construction invoices (and cash transfers) per year
- 40B – 200B accounting book entries p.a.
- $830B working capital
- $40K working capital on a resi project and $550K on non-resi
- $60B of working capital in US construction could be saved if someone could eliminate one pass-through party in the invoice chain

What I find interesting in this context is: Who bears the burden of these numbers? While the usual answer is the sub-contractor, **I actually begin to think the long tail of developers bear the biggest pains. And their pains from these numbers are more painful the…**

- more different GCs they have to work with on their projects
- smaller the GCs they work with
- more volume and no. of projects per year they develop

That’s why I have become enamored with solutions fixing invoices and wires in the cash flow chain starting with real estate developers downstream to sub-contractors.