If you're on a Galaxy Fold, consider unfolding your phone or viewing it in full screen to best optimize your experience.
Retainage is nine letters long, but for many contractors, it's a four-letter word.
Retainage, which is the practice of withholding a portion of the payment to a contractor until the job is done, not only shows a lack of trust in the abilities and trustworthiness of a contractor, it can also cause genuine financial hardship for small businesses that need to pay bills.
However, developers argue it's a necessary evil to protect them from projects that go awry.
What is retainage exactly, and how can you manage it as a small business? This guide breaks down some of the most frequently asked questions about this practice.
Retainage refers to money slated for a construction project that is withheld until the client deems the work substantially complete and confirms that the contractor has satisfied the contract. It's meant to protect the client's investment in the event that a construction project runs into major problems.
The practice started in the 1840s with the United Kingdom railway system. Increasing railway construction demand led to a flood of new contractors, many of whom were inexperienced and presented great financial risk to railway companies.
As a result, those companies started withholding up to 20% of payments to contractors until they were confident in the project’s progress.
The practice effectively put the contractor’s profit at risk rather than the investor’s money, increasing the incentive to execute the project well and disincentivizing underbidding.
Today, retainage is a common tool to reduce risk for developers, particularly for large-scale and complex projects where risks are higher.
In construction, the terms retention and retainage are mostly used interchangeably. However, in some cases, there is a slight difference: Retainage in construction may refer specifically to the money that is being retained, while retention refers to the act itself.
Even in this case, though, both terms essentially refer to the same thing.
Retainage is straightforward. For example, a client hires a contractor to build a 20,000-square-foot office building for $200 per square foot, or $4 million total. The contract includes a 5% retainage agreement.
The client pays the contractor $3.8 million to do the work and holds onto $200,000 for retainage. This retainage is released once the project is finished and the client signs off on it.
Retainage protects clients, but it can create hardships for contractors or subcontractors, who may struggle to pay their own bills because of having to wait longer to receive payment. Small construction businesses don't have deep pockets and have a higher chance of encountering financing issues.
Some contractors include retainage as a cost in their bid, which increases the cost to clients and prompts some of them to reduce or eliminate retainage altogether. Some states have passed laws setting a maximum retainage rate.
Retainage and retention fees differ depending on the type of job, the size of the project, and who the client is. For private jobs, you generally can expect an average retention of 7.5%, whereas state and federal jobs have fees that are typically less than that.
For federal contracts, contracting officers are allowed to withhold up to 10% of payment on a case-by-case basis, but restrictions prevent contracting officers from withholding money arbitrarily.
No nationwide federal law limiting retention rates exists -- however, some states have enacted their own laws. For example, Alabama limits retainage at 10% for private projects and 5% for public projects.
Virginia places no limit on private project retainage, but it limits retainage to 5% for public projects and allows contractors to place retained funds in an escrow account for public contracts exceeding $200,000.
Only one state -- New Mexico -- bans the practice entirely, although the law permits a "closeout payment" of 5% to 10% of the total contract value, meaning the practice is functionally allowed under a different term.
Usually, the client releases the money when the project is "substantially complete." What that means depends on the contract you signed with the client. Some developers will hold onto money long after project completion if the contract allows them to.
Carefully review any contract you sign with a client to ensure that it defines exactly what parameters must be met for the retainage to be released -- and make sure you're OK with this definition.
Many factors go into retainage, from your reputation to your relationship with the client to the size of the project.
For example, if your construction firm has gone over budget in the past with a client, and you're working on a much larger and more complex project for that client this time around, it's more likely you'll face a high retainage fee.
It’s possible, if your contract allows it. If so, you may have to bite the bullet and resolve next time to review the contract carefully and stipulate clear terms on what parameters you need to meet for the funds to be released.
If you did that and feel the client is withholding funds in violation of the contract, contact an attorney who specializes in contract law to review your case.
If you're a subcontractor for a prime and you've done your job, you may feel you're entitled to the retainage receivables in full, even if the prime is not yet finished with theirs.
In some cases, primes are allowed to withhold subcontractors' retainage until the entire project is done, but industry practices vary, and a lot depends on how the contract is written. Have a lawyer look over your contract if you're unsure.
Filing a lien is an effective way to collect on debt because it places a claim on the debtor’s assets, so it may be a good option for contractors seeking to get paid their retainage when clients drag their heels.
Look up state laws on lien-filing deadlines so you don't miss yours. The laws governing filing liens for retentions vary widely by state, so consult with an attorney first.
Not surprisingly, the practice is not popular with contractors and subcontractors, as it puts the financial burden on them.
The American Subcontractors Association (ASA) calls the retainage system "increasingly inequitable and counterproductive," and supports eliminating "unnecessary retainage" on construction projects as well as legislation that would prohibit a prime contractor from retaining a higher percentage from subcontractors than their own retainage rate.
Also, ASA supports legislation that would put funds in an escrow with accruing interest, so subcontractors would enjoy a bonus that would grow the longer the funds are held.
When you’re in construction project management, it’s helpful to manage your relationships with clients through construction management software.
The Ascent has reviewed a number of top platforms that will help you with construction document management and keep you on top of all your agreements and contracts.
Construction management software can do plenty of other things for your business as well, like provide you with a construction daily report, organize blueprints, and keep track of bids.
Disclaimer: This article is for informational purposes only and does not constitute legal advice. Consult with an attorney before taking any of the actions described in this article.
We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent, a Motley Fool service, does not cover all offers on the market. The Ascent has a dedicated team of editors and analysts focused on personal finance, and they follow the same set of publishing standards and editorial integrity while maintaining professional separation from the analysts and editors on other Motley Fool brands.
