As the Construction Practice Leader at Brown Edwards and Company, with nearly 22 years of experience working with construction contractors, I've helped many clients with business sales, acquisitions, management succession, and ESOPs. I've recently taken on an additional role overseeing our firm's valuation practice, which comprises seven professionals who perform business valuations for various purposes.
When Valuations Are Needed
Valuations are frequently required in several scenarios:
- Sale to an external party: Determining fair market value for potential buyers
- Transfer of ownership to trusts or family: Required by the IRS for gift tax returns or to establish fair market value
- Business mergers: Determining pre- and post-merger values
- Sale to an Employee Stock Ownership Plan (ESOP): Required for the independent trustee who purchases stock on employees' behalf
- Sales to management and key leaders: Establishing transition pricing
- Private equity investment: Determining investment valuation
Key Variables Driving Value
Several critical factors impact a construction company's value:
- Backlog: Both the quantity and quality matter - it must be profitable work that can be performed with existing resources
- Fixed assets: Particularly important for equipment-intensive companies like site or highway contractors
- Business relationships: The value of established customer connections and repeat business
- Customer base: Who you work with - governments, private industry, developers - affects stability and risk
- Economic trends: How your company compares to broader industry trends
- Succession planning: Having qualified people in place to ensure continued performance
- Risk factors: Multiple elements that could impact future performance
Valuation Approaches
When conducting a valuation, professional standards require consideration of three approaches, though one or more may be weighted more heavily depending on the circumstances:
1. Income Approach
Most commonly used for construction companies, this approach has two primary methods:
Discounted Cash Flow Method
This method determines the present value of future expected net cash flows using a discount rate. It:
- Incorporates projections of future net cash flows over several periods (typically five years)
- Includes a terminal value at the end of the projected period
- Uses a discount rate to determine present value
- Requires the company to reliably estimate future revenue growth, debt servicing, profit margins, and capital requirements
- Works best for companies with strong financial histories and reliable forecasting capabilities
When performing valuations using this method, we scrutinize growth projections. For instance, if a company has historically grown at 5% but projects 15% growth, we'll question the basis for this acceleration and examine its impact on working capital needs and capital requirements.
Capitalization of Earnings Method
This method focuses on historical earnings rather than future projections:
- Divides historical earnings by a capitalization rate that reflects anticipated returns and inherent risks
- Typically examines at least five years of historical data
- Makes common adjustments to EBITDA (earnings before interest, taxes, depreciation, and amortization):
- Owner salaries and bonuses (adjusting up if too low, down if they include returns that should be considered distributions)
- Related party transactions (rent, services at non-market rates)
- Non-recurring items (like PPP loans or employee retention credits)
- Personal expenses run through the business
This method works best for companies with consistent earnings patterns that are likely to continue into the future.
2. Market Approach
Guideline Public Company Method
This method compares the subject company to similar publicly traded companies. It's rarely used for small to mid-sized construction companies because:
- Few publicly traded construction companies exist
- Public companies differ significantly from privately held mid-market firms
- The method is generally only useful for construction companies exceeding $100-400 million in revenue
Transaction Method
This approach examines actual sales of comparable private companies:
- Uses databases of transactions classified by NAICS code
- Compares multiples (of EBITDA, revenue, etc.) paid for similar companies
- Helps validate valuations derived from other methods
- Requires careful analysis since companies can be in different markets with varying growth rates
- Often uses averages from multiple transactions rather than individual comparables
3. Asset Approach
This approach adjusts the book value balance sheet to reflect market values:
- Real estate values may require formal appraisals to establish current market value
- Equipment values often need adjustments since depreciated book values rarely reflect actual market value
- Shareholder loans or related party items typically get factored out
- May include valuation of intangible assets like reputation and client relationships
- Ultimately aims to determine goodwill
The asset approach is typically least indicative of actual value for profitable companies but becomes the primary approach for struggling contractors where the company's value is essentially its assets minus liabilities.
Valuation Discounts: A Powerful Tool
Valuation discounts represent one of the most important aspects of valuation, especially for estate planning purposes:
Lack of Control Discount
- Applied when valuing minority interests (typically 10-30%)
- Not applicable when valuing 100% of a company or controlling interests (>51%)
- Particularly valuable for estate planning when gifting minority shares
- Reduces the fair market value of minority shares significantly
Lack of Marketability Discount
- Reflects difficulty in selling business interests
- Applied even to 100% interests in private companies, though at lower rates
- Higher for minority interests since non-controlling shares are less marketable
- Compounds with lack of control discount for minority shares
Key Person Discount
- Applied when success depends heavily on specific individuals
- Less common but may be factored into the lack of marketability discount
These discounts are especially critical for estate tax planning. With the current estate tax exemption (approximately $13-14 million per person) scheduled to sunset in 2025, potentially returning to around $5 million per person, many more business owners could face estate tax exposure. Strategic gifting using these discounts can significantly reduce estate tax liability.
Risk Factors Affecting Valuation
Multiple risk factors influence valuation:
- Customer concentration: Over-reliance on few clients increases risk, though sometimes highly profitable relationships with key customers may outweigh diversification benefits
- Barriers to entry: Higher barriers (capital requirements, specialized skills, bonding capacity) generally increase value
- Competition: Your market position relative to competitors affects risk assessment
- Backlog quality: Unprofitable work or work exceeding capacity reduces value
- Economic cycles: Vulnerability to broader economic trends
- Location: Growth prospects of your geographic market
- Supply concentration: Dependence on limited material sources
- Management strength: Having a solid leadership team is crucial - buyers don't want to manage businesses themselves
- Estimation errors: Track record for accurate project estimates affects risk perception
- Litigation: Legal issues significantly impact valuations
- Regulatory environment: Impact of regulations on operations
- Weather patterns: Vulnerability to climate factors
Accounting Method Adjustments
Valuations typically adjust for different accounting methods to standardize comparisons:
- Cash method vs. accrual method
- Percentage of completion vs. completed contract method
- Moving toward GAAP standards (generally percentage of completion for contractors)
- Always examining the accrual basis regardless of the company's method
Rules of Thumb
While every valuation is unique, some general guidelines for construction companies include:
- Book value: Common for companies with inconsistent profit history
- Book value plus backlog multiple: Adding value for profitable backlog
- Revenue multiple: Typically 10-30% of annual revenue for successful contractors
- Cash flow multiple: General contractors: 2-3.5 times; Specialty trades: 4-6 times
These multiples can vary significantly based on circumstances. For example, one specialty trade contractor recently received 10 times cash flow from a strategic buyer backed by private equity.
Financial Ratios
When conducting valuations, we analyze several key financial ratios:
- EBITDA: Earnings before interest, taxes, depreciation, and amortization (though this shouldn't be the only focus)
- Working capital: Current assets minus current liabilities (excess working capital often added to enterprise value)
- Debt to equity: Total debt divided by shareholder equity
- Months in backlog: Backlog divided by (annual revenue ÷ 12)
- Profit margins: Both gross and net margins compared to industry benchmarks
- Seller's discretionary earnings: EBITDA with adjustments for owner benefits
Key Takeaways
To maximize your company's value:
- Focus on profitability, not volume: Revenue is rarely an indicator of profitability
- Implement succession planning: You cannot have a successful company without it
- Maintain a healthy balance sheet: Weak balance sheets significantly impact valuation
- Understand break-even analysis: Know your volume requirements for profitability
- Avoid claims and litigation: These create significant risk factors
- Develop your workforce: Critical for future performance
- Diversify services and customer base: Reduce concentration risk
Valuing a construction company combines art and science, requiring careful analysis of financial performance, risk factors, and market conditions. By understanding these elements, you can make strategic decisions to enhance your company's value, whether for sale, succession planning, or estate purposes.