When you have a contract where the performance will run over an extended period of time, most suppliers either can’t or won’t wait until the completion of the performance to get paid. This means that it will be necessary to negotiate some form of payment schedule.Many times suppliers will want either advance payments or they will want to “front end load” the payment schedule so they are financing the work with your money. Both of those approaches pay the Supplier more than the value of the work that has been performed at the time and can create problems. With any type of advance payment there are four things to consider.
First, advance payment impacts the cost to you if you needed to terminate the work. This limits your flexibility and may force you to stay with a problem supplier rather than lose that money.
Second, is the Supplier financially stable, where you payment will not be at risk. If you made an advance payment to an unstable supplier at best you would have a purchase money security interest in the product, at worst you would be an unsecured creditor in the event the Supplier ever went bankrupt.
Third is the leverage you lose in getting the job completed on time, especially if they already have been paid a significant amount of the contract value.
The forth aspect is the cost money. To pay them in advance you needed to either borrow the money or it took money away from other uses for that money that could have provided you a return on that money. An advance payment provides no return on the investment to the buyer, only a cost.
If you don’t want to make advance payments Suppliers may want a specific payment schedule for payments on specific dates. The problem with a date-based approach is dates alone have no link to performance of the work. You could have a Supplier that is way behind on the work and paying them on a specific date can create what is effectively another advance payment as they have not earned the amount of the payment.
There are three primary ways that you can avoid these problems. One approach is to establish specific milestones that are based upon the completion of identified deliverables and have a milestone payment reflect the value of the completion of that work and the acceptance of those deliverables. In doing this, your contract would need to specify the deliverables that must be completed or provided to meet the milestone, and the requirement that those deliverables must be accepted as a pre-condition of payment. The acceptance requirement prevents you from paying for deliverables that need to be corrected.
For contracts that may not have specific milestones, payment can be structured based upon the percentage of completion of the work. For example many construction projects have payments managed based upon the percentage of completion of the work as measured or established by a third party. For example if you used the UK building approach with quantity surveyors, they would establish the amount to be paid by their measurement of the work. If you didn’t have a quantity surveyor it could be the architect or engineering firm that would determine the percentage of work completed.
For both approaches the use of retainage is always a good idea. Retainage is the concept of withholding a specific percentage of the payment until the work is complete. You use retainage
as leverage to ensure that the work is completed. The supplier doesn’t get paid the retainage
until all the work is completed. There are a number of different ways that you can structure retainage. You could have retainage be a flat percentage that is retained from payments throughout the agreement. You could have the flat percentage up to a maximum amount after which no additional retainage is withheld. You could have a structure where upon the completion of a specific milestone a percentage of the retainage is released. For example in construction you could have two milestones that are defined. One is “substantial completion” where all the work is complete except for a minor punch list of items that need to be corrected. The other is final completion or final acceptance where all work has been completed and accepted per the terms of the contract. At substantial completion you might agree to reduce the amount of the total retainage and only after final completion or final acceptance is the remaining portion of the retainage released.
Progress payments terms can also be structured to manage performance. For example if a Supplier is late in meeting a milestone you could include language that if the Supplier is late by X number of days in meeting a specific milestone, that payment and subsequent milestone payments will not be made until the progress of the work is back on schedule. That forces the supplier or contractor to weigh the costs that would be required to get the work back on schedule versus the cost to them of not getting paid until they do.
Progress payments with retainage also helps in the event of a default by the supplier. Since the Supplier hasn’t earned the right to be paid the retainage when they defaulted, you have the amount of that retainage you can use to help complete the work.
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