Disputes in construction // No matter how thick you slice it, there will always be two sides

In Foundamental we look at more than 70 deals of early-stage tech companies in the construction sector per month across Asia, North America and Europe. One of the most frequent stats on founders’ slides we get to see is how much damage errors and rework are causing. These errors create a ton of claims and disputes in construction.

‘The degree of efficiency in an industry can be judged by checking its disputes.’

— Feodor Dostoyevsky, paraphrased

I recently realized that disputes are an interesting symptom of inefficiency in an industry. There are some industries that most people would call well-professionalized — for example automotive or aerospace — and where errors and disputes are under control.

After 2 years investing in tech companies in this space I can say: Construction is not one of those industries.

Here are my 10 slices on disputes in construction:

1/ The average dispute value on construction projects is around 8% of the project’s value. The average dispute then settles for around 2% of the value.

2/ And: for projects where the winning bid is 20+% lower than other bids, 70% of those projects have disputes.

3/ And: In North America, the main cause of dispute in 2018 was ‘errors or omissions in the contract document‘.

4/ But: Projects where the general contractor has a subjectively high expectation of future work with the same client, the rate of dispute drops to below 10%.

5/ Ergo: Contractors win contracts by underbidding. And: they claim 4x more than they settle for. When they are confident they win the next bid, they stop underbidding and stop claiming.

6/ Ergo: Incentives matter. A lot. Negotiation doesn’t stop with the contract — it carries on. The first incentive is winning the first bid. And then contractors want to win the next bid, ideally at a larger volume and better margin. Hardly a surprise for anyone who understands behavioral economics. But: at this scale incentives are out of control in construction.

7/ And: Transparency and objectivity matter. Getting away with a too low bid might not have been invented by the construction industry (defense industry, anyone?) but the EPC players might have perfected it. Opacity and un-objectivity result when speed or quality either (1) are subjective — which is fundamentally NOT the case in construction — or (2) are objective but cannot be measured objectively or (3) conditions or requirements change versus the initial agreement. What we see is this:

• Building code eliminates subjectivity in most mature markets
• The ability to measure in construction appears low. However: It takes a lot of work to do it in a high resolution and in almost real-time. Technology, to date, has not been on a level to monitor actual execution efficiently. This is changing dramatically.
• Changing conditions and requirements are a major source of opacity and subjectivity

8/ Ergo: Disputes happen because contractors have incentives to win projects, and because they get away with under-bidding or under-performing as under-performance can be easily attributed to changing conditions rather than execution. With increasing resolution of measuring project execution, transparency and objectivity increase dramatically. In turn, they improve an owners/developers ability to judge speed and quality within a project and across projects.

9/ Question mark we haven’t figured out yet: In 2018, the average dispute value was $57 million in Middle East markets, with an average time to settlement of 20 months. In North America, $16 million (= 28%) and 15 months. Possibly a result of different project values, but maybe other contributing factors such as code, competition and business practices as well?

10/ Founder opportunities: We would like to see more founders/companies systematically addressing the following angles:

• Efficient real-time objectivity — the challenge is not providing objective data in real-time. The challenge is collecting objective data in real-time, without delay. We see a lot of companies collecting data on site where the action is — we see yet too few companies systematically collecting data in what we call the “dark corners” of construction, eg. in payments/transactions, in trucks, and in ready mix plants and in timber plants. Think about collecting real-time data in those dark corners.
• Smart incentives (before you shout smart contracts and blockchain — you can do that more easily. It doesn’t need a distributed and untamperable database. All it needs is incentives tied to objective data). Think about ways to link a variety of collected objective data with contracts and financial transactions in construction — this is a big under-innovated space.
• Public performance objectivity — when a restaurant is crappy, the world knows about it. When a contractor is crappy — we don’t. Think about opportunities to publicize performance data.

As always, credits go to the data wizards in our Foundamental Insights group.

Sources:

• Arcadis Global Construction Dispute Report 2019
• Reducing Construction Costs: Uses of Best Dispute Resolution Practices by Project Owners 2017