Using Deposits in Residential Construction
As a professional residential contractor, you know that the most significant risk you face is not getting paid for your work. Unpaid work leads to cash flow problems, which is the number one reason why remodeling and custom home-building businesses fail. Without full payment for completed work, your construction business can't sustain the necessary expenses needed to run it, like employee salaries, overhead expenses, and materials and equipment required to build and remodel homes.
That's why you need processes in place to ensure that money flows into your business more rapidly than it's streaming out. Clients need to understand that you base your processes on a model that mitigates risk, makes you profitable, and cashflow-positive.
You aren't a bank, and the burden of covering the costs for any part of the project shouldn't be your responsibility to bear. This is why it's critical that you secure a deposit from clients when they sign a construction contract.
Deposits in Residential Construction
Deposits help secure a construction project in your pipeline, moving them from prospective work to an actual, billable renovation project.
They also make the remodeling or home renovation "real" for the client because they're committing money to it and aren't as likely to change their mind and back out.
But, sometimes, clients question why a general contractor's deposit is needed, particularly if it's for a renovation or new construction project that isn't scheduled to start immediately. And it's important to handle that objection easily by explaining the purpose of the deposit and how it will be used.
What is the Purpose of a Renovation Deposit
Simply put, taking a renovation deposit holds the time and space in your production schedule for a renovation project and secures the future cost of goods, like materials, labor, and trade partners, for that remodeling project.
A construction deposit is a commitment from the client to move ahead with the project. But, in the unlikely event that work is canceled after it starts, a deposit ensures that you, the remodeling contractor, aren't on the hook for any costs already incurred.
A construction deposit is also a guarantee for you that you will be able to cover the project's final costs. It's typically near the project's end when client concerns about money are at their highest, and the potential for disagreements with home builders is greatest. Having the deposit ensures you aren't absorbing those costs if a client refuses to make the final payment.
When you collect a renovation deposit, it's important to remember that the deposit amount is precisely that - a deposit based on the estimated cost of the entire build. It's not considered income because no work has been done against it.
We call this "Deferred Revenue," and it's best practice not to use it to fund current expenses on the project or to pay for other projects or overhead costs.
To learn more about deferred revenue and how it works, read this article on Work in Progress.
How Much of a Deposit Should You Ask For
The deposit amount needed for a new home or remodeling project can vary depending on the scope of the work involved and any state or provincial laws. It's a good idea to familiarize yourself with regional laws regarding deposit limits before collecting them from clients.
On average, many residential contractors aim to ask for around 10% of the total project cost as a deposit. While that may work for some businesses, it's important to remember that deposit amounts are not arbitrary numbers, and they should be charged on a case-by-case basis that considers the scope of work involved, the construction process, and the risk to you.
Residential Construction Deposits Are Not One-Size-Fits-All
To ensure you're covering yourself from any financial liability during the construction process, you may want to opt for a sliding scale when asking for client deposits.
Larger projects require committing to costs for external partners, like HVAC contractors, electricians, and plumbers, who all have several phases of a project and might be ordering equipment and materials that you'll still be on the hook for even if something goes sideways with the client.
On the other hand, smaller projects could require a larger upfront investment. For example, a $15,000 porch project might have a material cost of $5,000. If you stick with a 10% deposit, that only nets you $1,500, which means you're financing the difference, leaving you to assume all the risk if the project goes south.
Supply chain also plays a part in determining how much of a deposit to collect from clients. The pandemic and its lasting effects have forced many business owners to pre-fund above and beyond the typical deposits they would typically take because of longer lead times needed for materials.
If you need to pre-fund a dream home project with long lead time orders, such as windows/exterior doors, or cabinetry, you should bill those amounts IN ADDITION to the deposit. Those are expensive material costs you don't want to pay out of pocket and shouldn't be paid for with the deposit you've already taken.
Remember that you're a construction company, not a bank, and you shouldn't be financing any part of your client's renovation.
There is a status quo expectation in the construction industry that general contractors will finance costs and be paid back by clients. This is a false economy and puts too much risk on you.
How Long Before a Remodeling Project Should You Take a Deposit
Generally, when a client wants to move forward with hiring your residential construction company, three things happen:
They sign a contract
They provide a deposit
You cash the deposit check (because it's not "paid" until the money is in your account)
Remember that the paid deposit moves a project from prospective work into a billable job on your production calendar. Once a client confirms a project and signs the contract, that's when you should be collecting a deposit.
Deposits allow you to start actively working on pre-construction activities, so even if the project isn't slated to start for six to twelve months, don't postpone the deposit (or take a smaller amount) because the start date is so far away.
How Do You Credit the Construction Deposit Back to the Client
Once you've taken the deposit and started to work on pre-construction activities, it's important to start billing your client for time, materials, and trade partners' costs using a scheduled invoicing approach.
A construction deposit shouldn't be treated as income in the same way that regular payments are received.
Deposits are held until the end of the project to settle the final payment and credited back with the balance showing as "paid by construction deposit."
This ensures that if things take a wrong turn at any point in the project, you'll have enough cash on hand to pay for any committed costs without jeopardizing your profit earned to date on the project.
How to Talk to Clients About Construction Deposits
Asking clients for deposits upfront, and explaining how you'll apply the deposit, can be awkward, but if you've got a solid sales process in place, you should be able to cover this topic with clients easily.
Here are a few tips to implement:
1. Be consistent and build it into your sales model
Be upfront with potential clients about why providing a deposit at signing is necessary. Don't get caught up in anticipating how to respond to a client's emotional reaction - just stick to the facts. Let them know this is your construction process, and you can't put them on the calendar without it.
2. Remember that you're not a bank
Clients should understand that a deposit is not used to pay for the upfront and ongoing work costs during the renovation, fund change orders, or be used instead of regular progress payments. Ongoing costs are the client's responsibility and are paid for according to the payment schedule you've established for the project's length.
You're a builder, not a bank, and it's not your responsibility to take on the financial burden of paying for project costs. That's a surefire way to wind up going bankrupt.
3. Be Clear About How the Deposit Process Works
A new build or existing home renovation is a major investment for both you, as the prime contractor, and your client. And you are all taking a leap of faith in working with each other. As such, a client may be wary of giving a deposit because they've been burned in the past or heard stories about contractors taking deposits and not completing work.
Manage those fears by explaining how the deposit works and backing that information up in your builder contract. Remind them that a construction deposit is held "in trust" until the end of their renovation and will be credited back to them on their final invoice(s).
You can also direct them to testimonials from past satisfied homeowners on your website or online and offer to provide vetted past clients' contact details to speak directly with them to help allay their fears.
Why You Shouldn't Talk Yourself Out of Asking for Deposits
It can be uncomfortable to ask clients to pay for part of their renovation before construction has even begun. And it can be easy to justify to yourself why you shouldn't ask clients for construction deposits.
But talking yourself out of asking clients to pay a deposit adds too much risk to your construction business and leaves you open to financial hardship if the clients back out and you have to pay for committed costs if the project goes south.
Don't skip a deposit because you feel you "can trust" the client or because you think it's how an "honest and transparent" business operates.
Being "transparent" means talking with clients about the financial risks involved in residential construction and showing them how using a deposit process helps mitigate those issues and ensure a better outcome for everyone involved.
You got into this business to make a profit, which means not bearing the burden of funding a client's project or being in a situation where you're paying to go to work. Because in the end, if a client pulls the plug on you, it will cost you a lot of time, money, and effort to reclaim the funds you've spent.
I created the BUILD AND PROFIT SYSTEM to help custom home builders and remodelers run profitable businesses by implementing rock-solid processes and systems to ensure you aren't paying for the privilege of going to work.
Click the button below to learn how the BUILD AND PROFIT SYSTEM can help ensure you're being paid for all your work, from initial deposits to final invoices.
