The sale, purchase, or merger of a construction company requires an objective estimate of the company’s value. Many other issues call for valuation as well, including financing, succession, estate planning, tax elections, certain changes to ownership structure, insurance claims, and several other situations.
Some of these issues can arise suddenly, as when owners are forced to sell unexpectedly. Quick changes are always difficult to handle. Proactive planning ensures that a contract, rather than emotions, will control the process. Using a complete valuation as the base, and periodic updates, thereafter, helps contractors assess their place in the market regularly, including opportunities and risks, industry trends, and changes in demand.
The COVID Effect
Today we are all dealing with the ramifications of a global pandemic. While we are operating generally on a “local” basis, we now also must deal with this sudden change, that is none of our own doing. And, while we hope this all ends soon, the effects may be felt for some time. The future is more uncertain today than it has been anytime in the last decade.
As you will see below, a valuation is dependent upon estimated future returns for the buyer, and a risk rated discount applied to these estimated future cash flows. Most industries, not just construction, will have significant difficulties in assessing these two elements. The data points that we try to use are dated, usually nine to twelve months in arrears. Not having an up to the minute finger on the pulse does pose difficulties.
Present Worth of Future Benefits
Owners of a privately held company usually have strong emotional attachments to the organization they built and to the people they employ. Price may not be the only concern when succession plans pass control and management philosophies to family or employees. But in determining monetary value, the market uses objective standards.
A potential buyer or lender wants to know whether a construction company promises to deliver annual benefits, measured as operating cash flows, and/or appreciation, that are greater than the asking price. When we convert those future economic benefits into present-day dollars, we then have the current value for the company.
Standards of Value
There are various “standards of value.” Liquidation value, as the name states, is what a company’s value would be if all its assets were liquidated, voluntarily, orderly or otherwise. Fair value, sometimes used in ownership disputes, is often defined as the value of an interest just prior to the disputed action. It usually omits minority interest discounts, but precise definitions are governed by regulation or by state law.
Many construction acquisitions in recent years have been driven by investment value, which depends on an individual investor’s strategy. Investment value can vary greatly. It may soar above other valuations, as when the purchased company contributes an important synergy to the buyer. Investment value depends on who the buyer is, and what their motivations are.
A contractor with niche market penetration or success and familiarity in a certain geographic area or specialty performance skills, for example, may be attractive to a national player seeking to expand into the seller’s marketplace or build revenue mass. These motivations are unique to each buyer and depend almost entirely on the buyer’s circumstances. Beauty is in the eye of the beholder.
The most common term one hears is “fair market value” (FMV). FMV is the required standard in almost all tax applications and many business agreements as well. FMV is the cash price at which property would change hands between a hypothetical buyer and a hypothetical seller, if both were willing and able, free of any compulsion to buy or sell, and in possession of all pertinent facts. This is NOT a potential sale or transaction price.
Approaches to Determining Value
There are three commons approaches to business valuation:
The market approach looks at data, including stock issues and merger and acquisition information, for companies that are comparable in size, structure, markets, and service lines. Finding a comparable company or transaction is rare and discovering all the relevant details within a private transaction is almost impossible. Most contractor valuations will rely on one of the other two methods.
The cost (or “asset-based”) approach calculates the market value of a company’s assets, including contracts in place, minus its liabilities. Many contractors own real estate and/or equipment whose depreciation deductions render its book value lower than the market value for those assets. The asset-based approach adjusts asset values to their FMV as appropriate. This value may represent a baseline, the lower end for the company value
The income approach is the most commonly utilized method employed in the valuation of closely held construction companies. The appraiser attempts to calculate the present value of a contractor’s expected future earnings, using one of two methods. Discounted future cash flows or a capitalization of a single amount of cash, expected to repeat very evenly on into the future.
The events of the past year have now created an uneven, roller coaster expectation. So, no one cash flow amount, stable and repeatable, is expected over the next few years. We will be on a wild and at times unpredictable ride, until we reach a new “normal”.
The discounted cash flow method forecasts three to five years of future annual revenue, net income, and capital spending. And a future assumed exit price is calculated. After these are estimated, one converts these figures to cash flow available to an owner, and then “discounts” the cash flows to a present value using risk adjusted discount rates. This normally is a difficult process to complete, with many potential variations, and today, even more challenging.
Assets and Liabilities
Attaching monetary values to tangible assets like cash, receivables, and inventory is usually straightforward. But long-term assets such as facilities, equipment and land are more difficult to value, since their worth depends in part on their current use, their condition and location. For example, one bulldozer is new while another has pulled hard duty for a long time.
The value of a piece of equipment is usually based on the cost of replacing it with a like property, that is, similar in its capacity and its remaining useful life. The value of land or buildings can often be gauged by reference to the purchase price of similar property nearby.
Other assets are intangible and determining their value can be even harder. There’s no price list to consult for the value of strong customer relationships, a skilled and loyal workforce, favorable supplier terms, detailed business plans or well-ordered financial history, and job cost reporting systems. A contractor’s reputation for good work may be golden, but unlike real gold, that doesn’t easily translate into an objective value.
Intangible assets carry risks and over-reliance on them can present a major business risk. For example:
Many construction companies, especially those that are family owned, rely on a handful of employees to manage scheduling, estimating, and subcontracting. How likely is it that these employees and relationships will remain with the company?
A company with substantial revenues from one or a few returning customers will suffer if those customers go elsewhere. Who are these owners, and how will present circumstances influence their buying decisions? Will a change in the contractor ownership precipitate further indecision on their part?
Most business valuations approach these intangibles in combination with a company’s tangible assets. Without the ability to generate significant operating profits, the tangible assets themselves have little intrinsic value.
Liabilities are usually easier to quantify, including accounts payable, tax obligations, and debt. In assessing the liability involved in a bank loan (and any bonding) a valuation must consider any particularly high or low interest rates and any personal guarantees of debt or bonding by the current ownership group.
Even More Judgment Required Today
Construction operations involve more than its share of risk, and highly cyclical demand makes revenues and expenses rise and fall unevenly. New construction thrives in a healthy economy, renovation work more so during tough times. Typically, state budgets are cut sooner than federal budgets. Presently, a longer-term view toward any governmental budget outlook, at any level of government, is tenuous at best. Much of the industry depends, directly or indirectly, on governmental support.
Dependable project private financing is also critical to the industry. Where will the money come from? Private projects continually need long-term financing, banks most often, and these resources need to continue to be widely available for continued capital expansion. Times of uncertainty mean even greater risk, and these environmental risks must be considered.
Segments or other industries served by a contractor can also result in very different expectations and risks. If you build hotels, retail, manufacturing facilities, single family homes, apartment complexes, commercial offices, etc., each will have their own very different and specific expectations.
Contracts in place are the most reliable measures of future income, so contractors intending to sell would do well to retool and redouble their marketing efforts.
Discounts for Lack of Marketability or Control
Discounts can also account for a company’s lack of marketability-the difficulty of converting privately held assets to cash. Additional discounts might adjust value for a minority interest’s lack of control. Minority interests, on a pro-rata basis, are less valuable than controlling interests, who have the power to direct a company’s entire future, not to mention declare annual bonuses and dividends.
An Art, Not a Science
Whatever trade or service segment is involved, determining the value of a construction company remains a challenge. We are tasked with “estimating” a value for a particular purpose. It’s impossible to assign a precise figure until the company is sold, because only then can you know exactly what the traffic will bear. Meanwhile, contractors can control many of the elements that drive a company’s value, and these areas are where our efforts should be focused.
Valuquest, the business valuation unit within Bonadio, offers the highest level of valuation services. If you need assistance, please reach out to us. Anthony Duffy is the managing director of ValuQuest LLC. Tony is based out of our Albany, NY office, but covers our entire service area with a team of highly experienced individuals.
The information and advice we are providing for this matter relates to COVID-19 legislative relief measures. Because legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that could modify some of the advice and information provided to you, after the conclusion of our engagement. We, therefore, make no warranties, expressed or implied, on the services provided hereunder.
