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Preparing for transition
Succession Planning: Determining the Value of a Construction Business
Construction business owners seeking to sell their company should prepare as much as possible for the sale, and carefully assess factors impacting the value of their company.
We previously discussed what steps must be taken when passing a business on to family members and transferring a business to owners or external parties. Regardless of the identity of the acquiring owners or the transaction structure, the buyers and sellers will need to reach an agreement on the value of the company.
The true “value” of a company is the price at which its ownership would transfer from a willing buyer to a willing seller. Valuation methods are typically designed to provide an estimate of the price at which an ownership transition might occur. Professional advisors (including investment bankers who broker business transactions and accounting firms who provide business valuation reports) will be able to assist business owners in determining appropriate expectations for setting value.
There are many steps to consider when preparing for the sale of your company, and different methods you can use ensure a proper valuation. Traditional valuation methods include:
- Asset-based approaches, which separately value the assets of the company to determine the value of the company as a whole
- Market-based approaches, which use comparable sales of similar businesses
- Income-based approaches, which multiplies a company’s earnings or revenues by a return on investment
Valuation of construction companies most often centers on an income-based approach. In most cases, an income-based valuation will be determined by multiplying an earnings amount by a factor that is determined by an investor’s required return on investment. The earnings amount is usually earnings before interest, taxes, depreciation and amortization (EBITDA), and is often calculated on a “recast” basis to exclude certain owner-related transactions and normalize owner/manager compensation levels. Other income-based approaches will focus only on gross revenues to determine the value of the company.
Some construction companies will be better valued by looking to the value of their tangible assets. This may be particularly true for companies that have accumulated a lot of equipment and facilities over time. Construction companies that have a large service component to their business may also be best valued using a non-EBITDA-multiple method.
In addition to receiving compensation for the ownership interest, you should consider other factors, including:
- Does the owner separately own property (real or otherwise) that is used in the business and, if so, under what terms will those assets be sold/leased?
- If the seller’s input will be needed for some time period following the sale, will the seller receive continuing salary/consulting payments for a period of time after the change in ownership?
- Will the seller be restricted from competing with the buyer? If so, for how long and in what geographic region(s)?
Pre-planning for a sale
Some planning for a change in ownership can only occur at the time of the transaction, such as consultations with attorneys, accountants, and lenders, but it is important to do as much pre-planning as possible. Many elements of pre-planning will also be built into a well-written buy/sell agreement.
However, it is important to consider whether the company’s “entity structure” will help the transition. Many buyers will not want to buy stock of privately-held businesses operating as C corporations because asset sales create a double-tax to the seller. In some situations, buyers will only buy this stock at deeply discounted values. Companies operating as C corporations may want to switch to being taxed as S corporations. However, to avoid all levels of double taxation, the conversion may need to be made at least 10 years prior to selling the company’s assets.
While a recalculation of EBITDA (excluding certain owner perks) may be done at the time of a sale, business owners who know they may sell their business in the not-too-distant future might consider eliminating those expenses years before a transaction, since higher profitability yields a higher sales price.
While buyers review the historical performance of a company over a long time period (and look heavily at projected future earnings), they typically focus their attention on the year or two preceding the actual sale. Ensuring the company’s earnings in those years are solid (from both a positive performance perspective and from a “trusted numbers” (audited/reviewed financial statements) perspective) will go a long way in ensuring maximum transition value for the seller.
The following tips may help smooth the ownership transition of a construction company:
- Assess whether your workers are considered independent contractors or employees and whether your state tax filings are adequate, since these issues are carefully scrutinized during a sale transaction
- Removing lifestyle expenses from the company will improve profitability and, in turn, the sales price
- Deficiencies in insurance coverage can impact the company’s sale price
- Significant contracts and vendor agreements should be well-documented long before a transaction is completed, and should be assignable
Preparation helps the sale price
Although there are many factors that affect a company’s sale price, planning ahead as much as possible will ultimately help ease the transition and create an optimal business opportunity for any party involved in taking over your business.