The sale, purchase or merger of a construction company requires an objective calculation of the company’s value. Many other issues call for valuation as well, including financing, succession, estate planning, tax elections and 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.
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 benefits—in income or appreciation—that are greater than the asking price. When we convert those future economic benefits into present-day dollars, we then have the value of 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, for example, may be attractive to a national player seeking to expand into the marketplace or build up revenue mass. These motivations are unique to each buyer, and depend almost entirely on the buyer’s circumstance. 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 seller, if both were willing, free of compulsion and in possession of all pertinent facts.
Approaches to determining value
Three approaches to business valuation are in common use.
- 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 of the relevant details within a private transaction is almost impossible. Most 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 its market value, this approach adjusts asset values as appropriate. This value may represent a baseline, 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.
- The discounted cash flow method forecasts five years or so of revenue, net income and capital spending and converts these figures to cash flow, and then adjusts them back to present value using a risk adjusted discount rate.
- The capitalization of earnings method determines a normal, stable and repeatable earnings or cash flow base, then divides this amount by a capitalization rate that reflects degrees of risk and future growth.
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 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 books. 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 will remain with the company?
- A company with substantial revenues from one or a few returning customers will suffer if they go elsewhere. Will a change in ownership precipitate that change?
Most business valuations approach these intangibles in combination with a company’s tangible assets, without which they might have no value at all.
Liabilities are usually easy 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 current ownership.
Even more judgment
Construction involves 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. State budgets contract sooner than federal ones. Risk lowers value, and these environmental risks must be taken into account.
Contracts in place are the most reliable measures of future income, so contractors intending to sell would do well to 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 choose a company’s entire direction, not to mention declare bonuses and dividends.
An art, not a science
Whatever trade is involved, determining the value of a construction company is a challenge. It’s impossible to assign a precise figure until the company is sold, because only then can you know what the traffic will bear. Meanwhile, though, contractors can control many of the elements that affect a company’s value, and that’s where efforts should be focused.
Anthony Duffy is the managing director of ValuQuest based out of our Albany, NY office.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.