The Right Way to do Customer Deposits

How many of you are taking customer deposits? If you aren’t, let’s start there…because you should be. You should be charging some amount up front either at contract signing or it can be at funding of the construction loan, if they have a lender. The amount varies. 5-10% of the contract price is common.

The Benefits of the Deposit

As I see it, there are two primary benefits to the customer deposit. The first…it’s a good faith payment by the customer, so you can confidently move forward and begin doing things like purchasing material and mobilizing resources with less concern that the customer might change their mind or walk away. It ties them to the project.

The second benefit to the customer deposit is probably the most important. Every project you start is essentially a miniature business, a miniature company. And what do businesses need to survive? Obviously, cash. So, who is funding the project? Hopefully, with a good customer deposit, the answer is that your customer will be funding most of the cash needs for that project.

By cash needs, I’m referring to the working capital needs of the project as job costs and overhead are paid throughout. When you submit your draws and the customer or their lender pays those draws, they reset the clock in a sense, and you get caught up on your bills, but you’re almost never at zero. And in fact, you will likely almost always be underbilled to varying degrees if you don’t have that customer deposit working for you.

There’s a guy named Kurt Allshouse (he and his wife Sheri are accounting experts for contractors in Houston), and I told him once about this bright idea I had (by bright I mean idiotic) to eliminate customer deposits and use it as a selling point. And Kurt simply said to me, “You’re a builder, not a bank.” It’s true. And that idea I had was completely stupid, by the way. Luckily I never did it, because the deposit serves so that we aren’t financing the customers’ projects for them. That function carries a separate risk profile that we almost certainly never price in to our contracts.

The Risks to Foregoing the Deposit

And for those of you who are thinking, “Yeah, but we have strong working capital and cash positions as a company and we can afford to cover these interim project expenses between draws.” Well, I thought the same way for a long time, and if you’re fortunate enough to be in that position, that’s a good thing. That’s where we all need to be. The shortcoming in that thinking, as I now see it, is that it doesn’t cover for the risk that something might happen…

The project gets delayed for an inordinate amount of time for X, Y, or Z reason.

The customers gets divorced and halt the project, or decide to stop it altogether.

The customer’s lender, for whatever reason, decides to stop funding more draws on the loan.

The economy collapses.

These are all small risks, but after years in this business the small risks add up and the likelihood you experience something unexpected like this isn’t so small. So, in those situations, when the project could be delayed or stopped altogether, where do you want the balance of payments? Do you want to be floating some amount of money or have all your job costs covered?

So, to recap, the primary two advantages of the customer deposits are first as a good faith payment and second is to eliminate float, or put another way to maintain a positive balance of payments on a job at any given time.

The IDEAL Way to Structure the Deposit

Let’s move on to the RIGHT way to do a customer deposit. It’s actually very easy. You simply charge the deposit up front and then deduct it from the final draw.

Done.

I’ll illustrate…say you have a million dollar contract and you charge a 5% deposit, so $50,000. You get this deposit at contract signing, and then you begin construction as you normally would. You arrive at the point of your first draw, which let’s just say is the completion of foundation.

In this first draw you have several items, including foundation, plumbing rough, maybe some things like erosion control, port-a-cans, and your overhead and profit. Let’s keep things simple and say the total amount of this draw is $100,000, so 10% of the total contract amount. In this perfect scenario, the $50,000 customer deposit has helped you cover your costs up until the point of this first draw, and with the first draw you draw the ENTIRE amount of the draw. All $100,000 you are owed. This preserves the $50,000 customer deposit and keeps it in play as you progress through the project.

If you have 10 total draws throughout the project, for example, you would just repeat this scenario until you arrive at the last draw. And let’s just say that last draw is $80,000, or 8% of the total contract amount. On this very last draw, you give the customer credit for the deposit, reducing it by the amount of the deposit, so that the amount they owe you is $30,000, or $80,000 for the last draw minus the $50,000 customer deposit that they gave you up front.

It’s as simple as that. And if your customer is using their own money for the project, you have a simple, clean way to handle deposits.

The “Problem” When Lenders are Involved

The problem (there always has to be a problem in this business, right?) arises when lenders are involved. Many lenders need the builder to apply the deposit to specific budget line items, a silly notion to say the least. And much to my chagrin, my pleas for reason often fall on deaf ears.

In defense of the many fine bankers out there, it’s not their fault. They’re under a tremendous amount of red tape and regulatory scrutiny. But there’s a little something called accounting, and accounting says job cost expenses are one thing, and HOW those expenses are financed are another altogether separate thing. When a bank requests that you show the budget line items where the deposit will be applied, they are indirectly negating the main benefit of the deposit. I’ll explain using the same illustration as earlier.

In the million dollar contract example, the customer has a bank that tells you they require you apply the deposit to budget items. So, to keep things really simple, you go and apply the $50,000 deposit to the foundation. The banks says, “Okay, thanks. Here’s the deposit.” NOW, a few weeks later when you finish the foundation and go to apply for your first draw, which we established was $100,000, the bank is going to say, “Here’s $100,000 minus the $50,000 deposit we already gave you,” and you’re gonna take home a net check of $50,000 from that first draw.

So, in this example, you will have a completed foundation and will have been made whole by the lender. They gave you a $50,000 deposit, which served as working capital for the project during that first draw, and then the bank deducted that deposit from the first draw. Well, you have been made whole at least, but the problem is now you are about to start work towards items on the second draw (think framing), and the deposit will gone. You no longer have the benefit of the deposit. It eroded with that first draw.

In the ideal way to do it that I already outlined, you would still have that $50,000 deposit to help for the duration of the project. So, what’s the answer if there is a lender who is requesting the deposit be applied to various budget line items? Well, ideally, it’s to find a lender who truly understands the issue and allows you to utilize the deposit in the correct manner.

The Solutions

Obviously, relationships come into play and your or your client may just not have a lender who can agree to what I’m proposing. In that situation, Plan B should be to apply the deposit to the budget line items that compose the final draw (think landscaping, punch, final cleaning, etc). The lender may allow you to do this, and practically-speaking it’s almost the same as the ideal way to do it. And if a lender won’t agree to that, which they quite possibly won’t based on their internal policies, you can see if they will apply it to your overhead and profit. This isn’t a great solution though, as it doesn’t erode the benefit of the deposit all at once early on, but it does erode it in somewhat of a linear fashion over the course of the project.

I’ve seen some builders add actual budget line items for the deposit, but if you do that you have to go mess with your budget to find items to reduce by the same amount and things gets jacked up and you end up in the same boat.

In Summary

To wrap this up, just remember, if you get into a situation where the deposit gets applied to budget items, you will at that point in the project lose the benefit of the deposit, and the entire risk profile of the project will shift at that point. This usually isn’t an issue if the customer is using their own money, but with a lender it’s more complicated. Try to get them to agree to one of my strategies I outlined. You’ll be in a much better position if you do.

BTW, if you are looking to improve some of your company’s systems, head on over to the Building Optimal Shop to check out some of our swag to build a better business. Proceeds go to benefit, Exponencialistas, my non-profit investing in entrepreneurs transforming their communities in Latin America.