Do you know how much your construction company is worth? Probably not. But knowing the value of your company should be an important part of your business plan.
Why Would You Need a Valuation?
The most obvious reason for wanting a valuation is if you’re considering selling your business. You never know when an attractive opportunity will present itself. Even if you want to sell only a portion of your company, you need to know the value of the interest being transferred.
The second most common reason for valuing a closely-held construction business is estate and gift tax planning and return purposes. You may have worked a lifetime to build your business into a profitable, well-run operation. However, unless proper planning is done well in advance, you can have your company’s resources depleted through estate taxes. You should either plan to arrange in advance to transfer the ownership or provide sufficient insurance to pay the estate taxes.
One viable estate planning tool that remains is the use of the unified gift and estate tax credit. In 2018, before any changes resulting from pending tax reforms, this credit is a maximum of $5.6 million for an individual and $11.2 million, with portability, for a married couple. Another often-used vehicle is the annual gift allowance schedule, which is $15,000 per person in 2018. For any such transfers of stock in a closely-held business, you need to know the value of the stock being transferred.
The third reason to value your construction company is for use in a buy-sell arrangement between heirs of the owner’s estate and a purchaser. A buy-sell agreement will often include a life insurance requirement. The insurance must be updated annually to ensure that the company is maintaining insurance sufficient to fund the purchase of the company’s stock from the deceased owner’s estate. Buy-sell agreements can take a variety of forms, but all require a periodic valuation of the company stock if they are to be useful.
Other Reasons for a Valuation
Below are some less common reasons for needing to know the value of your company:
- Selling Ownership (Total or Partial) to Key Employees — Directly to individuals, a private company, or private equity group or possibly through an employee stock ownership program (ESOP).
- Litigation — If the principal of the business is involved in a divorce, the business will probably have to be valued as part of the property settlement.
- Financing — Established construction companies often have large amounts of heavy equipment. This equipment is often paid for and fully depreciated, but it still has substantial value. Contractors may need to have the equipment valued for purposes of refinancing or securing new debt. You may also need to have your company valued in order to obtain financing when you’re securing debt with the stock of your company. It is also applicable for financing faster growth and expansion than you could achieve through internal financing methods.
- Mergers or Acquisitions — If you plan to merge your company or acquire another company, you need to know the relative fair market values of the business enterprises concerned for financing or exchange of stock purposes.
- Going Public — Since sales to private equity groups are more likely today, public stock offerings are becoming less common in the construction industry, but are still possible. You would be required to have the company valued for purposes of establishing a share price and to negotiate a fair price with the underwriters.
- Retirement Planning — Your long-term goal may be to comfortably retire on the proceeds of selling your company. A periodic update of the value of your company would be very useful.
- Measuring Your Return on Investment — Owners of closely-held businesses will only seldom commission an evaluation of the return on their invested equity.
For example, if your company was valued at 52 million and produces a pre-tax profit of only $550,000 per year, your return on investment would be 2.5% per year. In cases such as this, selling the business and investing the money may make better sense than risking your equity for such a low rate of return.
When you engage with a qualified industry valuation expert to value your business, what you learn may surprise you.
For instance, you may perceive the strengths or weaknesses that were previously overlooked in the day-to-day operations. Having this information could ultimately increase the value of your company if you make changes to your operations that improve profitability or management ability.
Sureties are also increasingly concerned with these same issues of profitability and management. Many bonding companies are beginning to require a continuing business plan, including a business valuation.
Why are sureties instituting this requirement? They’re concerned that the impact of a large estate tax bill, combined with the loss of management, could affect the ability of the construction company to remain profitable or stay in business if the principal should pass away.
The Mechanics of Valuation
Each business is unique, especially construction companies. Even though all contractors are classified as construction companies, the business of a general contractor is very different from that of a trade contractor, such as an electrical contractor or mechanical contractor.
Putting a price on a construction company is complex. Cost, income, and market data must all be considered in order to form an opinion of value.
Each of the following approaches has advantages. A valuation professional will usually use at least two, and perhaps all three approaches.
The Cost Approach will look at how much it would cost to reconstruct or replace your company (or certain assets that are part of it) with another with similar attributes. When applied to the valuation of owners’ or stockholders’ equity, the cost approach requires a restatement of the balance sheet that substitutes the fair market values of assets and liabilities for their book or depreciated values.
- The Income Approach looks at the present value of the future economic benefits of your company. That future is then discounted at a rate commensurate with alternative investments of similar quality and risk.
The Market Approach measures the value of your company, or its assets, by comparing it to similar companies that have been sold or offered for sale. This information would usually be compiled from statistics for comparable construction companies. Where the price represents a majority interest, the higher value is recognized and reflected in a higher price or a premium paid. However, the value of a closely-held company or its stock must reflect its relative illiquidity compared to publicly traded companies. A discount, or a reduction in the indicated marketable value, is made for this factor.
Planning for Your Future
With so many reasons for knowing the value of a company, having an annually updated valuation is becoming more of a commonplace. A good business person knows his position and options at all times so he can make well-informed decisions.
Aronson has extensive experience with the special business planning needs of contractors and the various methods for conducting a valuation. For help or questions regarding determining your contracting operations value, please contact Tim Cummins or one of our construction specialists at 301.231.6200. For more, read my next blog, “Two Methods for Valuing Your Construction Company.”