Not all contracts are created equal.

Nov 17, 2022

Main topic: Different types of construction contracts.

One of the most important things to consider when implementing a contract is that it must be appropriate for the scope it is meant to cover. This applies to all aspects of the agreement, from the fee structure to the terms. In development projects, construction contracts are the backbone of the job, and the process of creating and negotiating them sets the tone for the project's execution.

Since contracts must be appropriate above all, we find ourselves in that uncomfortable spot where I preface the newsletter with "it depends." Not all construction contract fee structures are the same, so ensuring you have the best structure for your project is critical. Before we get to the juicy parts of fee structures, there are some minimum contract basics to cover. In addition to the general thought that a contract should be specific to a project, a contract must:

Be unambiguous. This applies both to the agreement terms and the exhibits. It is essential to ensure that counsel actively looks out for language modifications through negotiations that may create ambiguity. The last thing you want is to try to remember the 'spirit' of a particular clause two years and a lot of heartache later. You certainly don't want to leave it to a judge to decide! Additionally, watch out for term language in exhibits. Although most contracts will include language regarding whether the agreement or the exhibits take precedence, it is undoubtedly better to strike out all terms from exhibits and negotiate terms as part of the contract. Leave the exhibits for scope and service descriptions, including time and fee schedules.
Include a termination for convenience clause. You should be able to terminate a contract for any reason, whenever you need to. For this to be even-handed, most opposing parties will request that this be mutual. A termination for convenience clause should come with a notice period and stipulate that payment will be required for all work accepted until a termination notice is issued.
Provide adequate Indemnity/Insurance. Typically, lenders and insurance companies will require that you add specific language in this part of a contract. Request that your lender and insurance company review this particular section to ensure limits and language meet their standards. Additionally, since development projects sometimes have complex entity structures, ask your development and/or construction counsel to help you figure out which entities in the project structure need to be named here. Bonus: the entities listed in this section are likely to be the same ones required to be listed in the certificates of insurance required for the project.

These apply to all types of contracts (for consultants, too!) In the next newsletter installment, I will cover basic construction contract terms in greater depth, but this edition would not be complete without mentioning these simple fundamentals.

As we return to the main topic, it is relevant to note that establishing the project's fee structure should be a collaborative process between all parties, including construction counsel. This brings us to the standard advice I give all my clients: make sure to at least consult briefly with specialized counsel-- and no, your tax, divorce, traffic, or development attorney is unlikely to be able to navigate the nuance of construction law. I am also not a lawyer, so this newsletter intends not to provide legal advice but to lay out the basics of the industry-standard fee structures for educational purposes.

Finally, individual contract terms may incorporate elements from different structure types discussed below and even include additional terms to make the agreement as adequate as possible, giving the project a strong foundation.

1. Lump Sum.

When is it best to use a Lump Sum fee structure? When the project is small, and all team members are very familiar with the scope, including the owner, design team, and contractor.

Generally, Lump Sum is the best structure for projects with a contract price around/under $3-4M. They are handy for repetitive scopes within this cost range, too. A great example to draw from my experience is branded select-service hotel renovations that are highly standardized and usually performed on existing buildings. In this example, the material finishes are all pre-specified, the guidelines for the scope are also pre-determined, and the niche design and contracting teams that work on these types of projects are so familiar with the product that they can anticipate many of the potential surprises. This makes this type of project a great candidate for a Lump Sum structure, whether standalone or as part of a large portfolio. Generally, this can also be a good structure for interior renovation projects at or below $2-3M, where the drawings are at 100%CD, and there are no major expected site surprises or design changes.
One misconception about Lump Sum contracts is that the risk is completely transferred to the GC/CM and that the owner will never see a change order. This only applies to the scope included in the agreement via drawings or scope narratives. Typically, contractor bids for Lump Sum agreements have an extensive list of exclusions-- so make sure to review those before inking the deal. Anything purposely excluded or not included in the initial contract scope will be a change order presented to the owner.
Some of the things an owner should watch out for in Lump Sum agreements are the contractor markups on change orders and 'closed book' terms. Typically, this fee structure will carry a higher markup on change orders than a Cost Plus structure. I always recommend aggressively negotiating CO markup to 10-15% maximum, which is industry standard and plenty fair. Standard Lump Sum contracts are also likely to have 'closed book' terms. This means the contractor is not obligated to share subcontractor pricing with the owner. I always recommend against agreeing to this, regardless of the fee structure. I don't believe this is a fair standard or that it makes much sense. The project owner should be able to know how much they are paying for the work, and the contractor's markup should not be a secret. In my experience, this type of transparency promotes better behavior from all parties. Additionally, there are many lenders and institutional investors that require subcontractor audits. As a GP, you don't want to be non compliant with your obligations to LPs or lenders because of a contract oversight!

Lump Sum contracts are outstanding for well-defined, lower-cost scopes, making them ideal for limited renovation projects. This fee structure is less useful for larger projects or projects with more certainty regarding design or site conditions. For instances with less certainty, Lump Sum contracts pose an increased risk to the contractor, which they will likely mitigate by increasing their markup or fees. For this reason, discussing the fee structure with the contractor is essential to ensure that their perceived risk is not costing you more than it would if the price structure was different.

2. Unit Price.

When is it best to use a Unit Price fee structure? When the total project scope is unknown but easily split into sections (or units), and the owner has the capacity and interest to heavily audit billings.

Unit Price contracts are somewhat funky in that they are essentially a group of Lump Sum contracts bundled into one. Therefore, most of the tprinciples from the previous section apply to this fee structure. The advantage of a unit cost contract is to lock in markup rates and material pricing. This works particularly well when you have repetitive work, and the total scope is still unknown. Typically, this agreement will include a time cap on how long the work can extend before the contractor is allowed to 'remeasure.' This means that after a certain period, the contractor may reprice labor and materials to reflect changes in the market as expected when the contract covers a longer period (12-18 months is typical).
Sometimes, this fee structure is used in private projects, where the timeline is highly variable as a result of uncertain financing, but the total project scope and phasing units are clear. This hedges (initially) better than a Cost Plus agreement, where potential owner-led delays could amount to a considerable price increase (even when a GMP* has been established). Again, like in public projects, the 'remeasurement' period is important and, if exceeded, could result in a considerable cost increase. For this reason, it is also important to negotiate good demobilization/remobilization terms in Unit Price contracts to help hedge against owner-led delays.
As with Lump Sum agreements, Unit Price contracts are likely to carry a higher contractor markup vs. a Cost Plus contract for a similar scope. Additionally, the total project cost is likely to increase beyond the markup via remeasurement and mobilization fees. For this reason, Unit Price contracts are rarely used since they are created for instances where it is known that project efficiency is not a priority and getting the work started (not necessarily finished) sooner rather than in a more cost-conscious manner is the primary goal.

To sum up, unit price contracts are great for instances where the total scope and timeline are unknown, but some definition of the 'unit' is clear. This makes this type of structure most appropriate for government projects or phased renovations where the entire timeline may depend on factors outside the project team's control. Despite having advantages and adequate applications, this fee structure is rarely used in private development projects because it is nearly impossible to estimate or even control the total project costs. So, unless you have a unique financing situation or are working on a government job, it is doubtful that a Unit Price cost structure is the right one for your project.

*For GMP details, see #4 below.

3. Time & Materials.

When is it best to use a Time & Materials fee structure? When the project is small, the total scope is known, and very little to no coordination is required between trades.

Time & Materials (T&M) agreements are typically most appropriate for very limited scopes involving predominantly a single trade that is contracted directly. This fee structure is excellent for projects where the trade involved does not need much direction from the owner aside from overall schedule and access to the work area. T&M contracts are sometimes also appropriate for small <$50K work scopes that encompass several trades but that a general contractor could self-perform. The key to this fee structure's advantage is that the time and materials must be easily quantified. This can begin to get complicated (and expensive) when coordination between different parties comes into play, resulting in a lot of wasted time. So, if coordination is required and you don't have the time or expertise to manage it (be honest with yourself on this one!), then this is not the best fee structure for you.
As an owner using a T&M fee structure, you should ensure rates and material pricing are included in the initial contract document as an exhibit. The agreement should also have 'open book' terms so that material invoicing and time sheets are readily available and, if necessary, required to be submitted on a weekly or biweekly basis. Another key to taking advantage of this pricing structure's benefits is ensuring you have the resources to review invoice details for time and materials billed. This will require the owner to have somewhat of a permanent site presence to ensure the work in place matches s invoicing.
Sometimes, a T&M structure may be used for sections of the work covered in a bigger contract, particularly regarding change orders. For example, when you have a lump sum or a GMP for the project, but now you have changed your mind regarding a flooring material that has already been installed. If you have a good relationship with the contractor, they may agree to price the change on a T&M structure and then add their markup per the original contract (technically a Cost Plus structure). There are instances when T&M doesn't work so well for change orders, and you guessed it-- when the change requires coordination of many trades. In those instances, it may work out better to price the change as a lump sum.

To summarize, Time & Materials agreements are outstanding for single-trade work scopes that require very little coordination or management. Once oversight is needed beyond basic site supervision, this fee structure is less successful. Last, another significant advantage of this structure is that nearly every trade and contractor in the business is familiar with it since it is as simple as it gets. This means that when dealing with less sophisticated teams or teams in a new market, this may be the way to get the most transparency from the crews performing the work.

4. Cost Plus.

When is it best to use a Cost Plus fee structure? When the work is complex and requires coordination of several parties, including trades, consultants, and jurisdictional officials (inspectors, etc.). Since many typical project scopes fall into this category, it is only to be expected that this (along with Lump Sum) fee structure is one of the most widely used. Cost Plus is also the basis for a Guaranteed Maximum Price amendment, and it builds on many of the principles laid out under the other fee structures above, which is why I have saved this one for last.

Usually, Cost Plus is the best fee structure for projects with a contract price over $5M, where the ultimate goal is to set a Guaranteed Maximum Price for the work towards the end of the Construction Documents process. Setting a GMP essentially draws on the benefits of a Lump Sum agreement where the final price (or close) is understood early in the construction process while still allowing the development/construction team to bid out all work scopes in order to receive the most competitive pricing.
The Cost Plus structure is very straightforward. It is essentially the cost of the work (time and materials) plus the contractor's fee, taxes, general conditions/requirements, and insurance. When negotiating a Cost Plus agreement, whether a GMP is expected or not, it is important to ensure all scope that belongs in the 'cost' and 'plus' buckets is correctly identified and agreed upon. This is not the contract structure to gloss over the details on! Be exceptionally watchful of things included in the General Conditions/Requirements categories.
Just like with a Lump Sum structure, a common misconception of a Cost Plus + GMP is that the owner is safe from change orders. Establishing a GMP does not necessarily mean the owner will not receive change orders. A GMP only covers the scope described in drawings, specs, and narratives provided to the contractor during the GMP negotiation process. Any unexpected conditions and design or spec changes from the original contract documents will cost the owner. This is why it is vital to begin the GMP negotiation process only after the design documents are close to complete (at least 85%+) and several trade hard bids have been received, framing the pricing in the reality of the market.
The process leading up to a GMP is relatively straightforward.
- When the first step happens depends on whether or not the owner wants/needs the contractor to be involved in the preconstruction process while design is ongoing. If input from the contractor is preferred during design, the best time to bring the contractor on board is soon after Schematic Design begins and no later than the start of the Design Development phase. This maximizes the possibility for early design input from the contractor, reducing the need for value engineering down the line. The farther along the design is, the more time is required to implement cost-saving changes in the later stages of design when deadlines become more urgent, compounding the negative effect of a late collaboration start.
- If collaboration with the contractor is required during the design process, a formal agreement should be struck. This is extremely important as it can significantly impact the owner's liability. At this point, there are two main avenues to get the contractor on board:
  1. A preconstruction agreement. This first option is simple and widely used. It is best when the owner is unsure if the contractor selected for precon is the right one for the job and when the timing of project completion is not a significant factor in the deal.
  2. A Construction Management Agreement (CMA) that is then amended with GMP terms. This second option is also widely used and the most time-effective solution since it will require upfront negotiation of many terms like liability, insurance, contractor responsibilities, precon fees, and team structure, leaving only the negotiation of GMP terms like shared savings, total contract price, and change order markups, etc. to the end of the design process and right before construction begins. This method also provides the benefit of establishing a contractual framework should there be a need for the contractor to begin work on a limited construction scope before finalizing GMP terms. This second option is the method I almost always recommend and use.

A Cost Plus + GMP agreement is arguably the gold standard fee structure for construction agreements when it comes to large projects. More and more industry players (contractors and developers) are adopting this as their default approach to commercial development work. This multi-part structure certainly offers many benefits but requires more upfront contract work from all parties compared to other fee structures. Often, negotiation fatigue takes over, and either party stops paying attention to the details as they approach finalizing the agreement. This tends to lead to a difference in expectations when solving disputes, creating situations that could have been easily avoided. Ultimately, negotiating a GMP from the owner's side is more about patience and curiosity than anything else so long as counsel is adequately capable of handling the legal terms.

Bonus: Contract Structure - Short Form vs. Long Form.

Finally, this is a short bonus section to round out the newsletter's main topic. What are the main differences between long and short-form agreements, and when are they appropriate for construction work?

Short Form. Short Form agreements are short for a reason. Keep this in mind! A Short Form contract (AKA as a PO or Purchase Order contract) is appropriate when services are straightforward, limited in scope, and typically under $50K. (This is different for consultants, particularly for architectural services agreements where professional liability is also at play.) The main idea behind a Short Form contract is to cover just the basics of insurance, indemnification, termination, price, and governing law. Part of the reason these are short is that the services do not require lengthy descriptions or inclusions/exclusions. As a general reference, these agreements are around ten pages long and should not take more than one or two document turns to negotiate. A strong Short Form contract may also adequately serve as a 'letter of intent' when immediate commencement of work is required, and Long Form agreement terms are expected to take several weeks to be worked out.
Long Form. Long Form or Standard contracts are the typical 30+ page documents that cover as much detail as possible. This is usually required when the services covered in the contract are numerous and expected to change as time progresses. So, in addition to covering the basics that are also part of a Short Form agreement, Long Form contracts should include additional detail in the description of obligations, liability requirements, payment terms, etc., as they apply to the complex service offering that is expected to evolve through the life of the project.

This is another aspect to consider while establishing which contract structure will best fit your project. As previously discussed, this conversation should include construction counsel and occur as early in the process as possible.

The beauty of contracts is that they aren't a 'one-size-fits-all' item, which means that as long as your terms are within the market, creative and appropriate contracts can provide your project with a robust framework for construction by way of ensuring the contractor and ownership sides are well-aligned.

This aspect also makes crafting a good contract a little bit of an art, where the details make all the difference. Ultimately, this means that as an owner, your familiarity with the agreement and its nuance is essential for the successful execution of the contract, which leads me to the last bit of advice: read your construction agreements more than once and make sure you understand to a reasonable extent what the significant terms mean.

The main intention of this newsletter (at minimum) is to equip you with information that may help you either to approach construction counsel with pointed questions regarding your contract's fee structure or to have a more informed conversation with a contractor you're negotiating an agreement with.

Ideally, the takeaway is not only a general grasp of these different structures but also a deep understanding that a well-crafted, suitable contract can make all the difference in a project. This is particularly applicable to large projects (~$5M+) and for instances where you have small projects at volume where the scope is somewhat repetitive, and the creation of a tailored contract template will likely save you time.

Not sure where to start and think we can help? You can find us here!

Main topic ideas for future newsletters.

Between conversations with clients, industry professionals (and RE Twitter) these are some subjects we will be diving deeper into in future newsletters.

Creating contract templates (guest newsletter writer)
What is MADDPROJECT's consult service for?
How to create an Anticipated Cost Report

Have a specific subject you want to see us tackle? Drop us a note!

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