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Key Drivers of Value in Construction Companies
Business valuation in the construction industry may be more important today than ever as the poor economy takes its toll, the industry consolidates, and a generation of owners considers selling to family members, employees or outside buyers.
Many construction company owners think they know what their business is worth, but the value in the marketplace may be much different than the perceived value to the owner. Consulting with a valuation professional will ensure that you understand the value of your business and that your planning is based on a sound footing.
If you want to sell your company for its highest possible value, you need to understand how construction companies are valued, and what you can do to increase that value.
Valuation professionals generally employ one of three approaches to business valuation:
- Asset approach — The asset approach is used for businesses where the current returns available to shareholders do not adequately reflect the fair market value of the business in its entirety. In other words, the earnings generated by the company do not create enough business value over and above the net assets of the company. There is no "goodwill" or "blue sky" value in the business. With this approach, the assets and liabilities on the balance sheet are adjusted to fair market value and the resulting equity reflects the estimated fair market value of the business. You often see this approach used for holding companies and equipment-intensive construction companies, such as road builders and earth movers, that show losses or modest earnings in the last few years.
- Market approach — The market approach looks at similar companies, and comparable public and private transactions. The valuator looks for actual sales of similar companies and uses multiples to determine a value. The valuator may also look for comparable public companies and use multiples to determine value. The problem with this method in the construction industry is that it is sometimes difficult to find companies that are truly comparable. Using public companies as indicators of value is generally only appropriate for very large construction companies because it is difficult to find comparable public companies that can be relied upon for valuing smaller construction companies. Private transactions often don't yield enough comparable transactions to be reliable.
- Income approach —The income approach uses historical earnings or estimates of future cash flows and present value techniques to derive current value. The most significant items of consideration are the income stream selected and the discount rate.
Key value drivers
In order to know how to maximize the value of your construction company, you first need to know the key value drivers. There are three main drivers of value in a construction company:
Cash flow is king in any valuation. Therefore, to maximize the value of your construction business, you need to dress your financials for success. Without a recent history of positive cash flows, value may be limited to the net asset value. Of course, you cannot change the past, but prospective earnings are significantly more relevant than historical earnings.
All other things being equal, a construction company with lower future capital expenditure needs (due to prior investments in equipment, etc.) will be worth more than a similar company that has higher future capital expenditures. Delaying investments in machinery and equipment can harm the company from a value perspective, because future cash flows will be required for capital investment rather than as a return to the investors. Another important factor is whether those earnings are from repeat customers, or if a significant percentage of the earnings are derived from new sources.
Management depth and succession
It is essential that a company's key employees have employment contracts and noncompete clauses, or separate agreements to ensure value transfer. Noncompete agreements must be legally enforceable (laws vary from state to state), geographically limited and time limited. Both parties should give up rights and received a benefit from the agreement.
If a company has a sole owner, or there is a small number of owners, and the services, knowledge and relationships of the owner(s) are vital to the success of the company, there may be personal goodwill to consider. This goodwill is owned by the individual or individuals, not the company, and cannot theoretically be transferred by the company to a buyer.
Without a noncompete agreement, a buyer may discount the value of the company to account for the inability to prevent the key employee or owner from taking away future revenue of the company.
A word of caution: If an owner enters into an employment or noncompete agreement, doing so may eliminate an opportunity to treat the sale of personal goodwill as a personal asset, subject to capital gain rates, rather than ordinary rates.
Is the company known for a specific kind of construction – residential, commercial, government, institutional? Who are the major competitors? Why should a buyer choose this company and not the one down the street? If a company has a strong geographic presence or is located where the economy is strong, it may be difficult for a competitor to penetrate, thereby increasing the value of the company.
A construction company that specializes (C-stores, hospitals, restaurants, franchises or government facilities, for example), can usually do so faster and cheaper than a contractor who doesn't specialize in a niche area. Specialization generally allows for a competitive advantage and higher margins. However, if the industry in which the contractor specializes is in a downturn, there is a greater risk of financial failure than with a non-niche contractor.
Other factors can also create a competitive advantage:
- A written succession plan
- Cross-training at key levels of management
- Two-deep leadership in key areas
- A strong working capital position and creditworthiness
- Specialization (hospitals, restaurants, franchises or government facilities)
Armed with this knowledge, you can put plans in place to increase the value of the company in the eyes of the prospective buyer. The best way to assure an accurate and appropriate business valuation is to involve a valuation professional from the start.