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Business owners should understand what really drives business value if they expect to make their companies more attractive to potential investors.

By Erin Hollis

Here’s a reality check: The construction industry is competitive, and many industry sectors are saturated with thousands of look-alike firms. Recent data indicates:

• Fifty-eight percent of highway and street construction companies generate revenues of less than $1 million; only 9 percent have revenues between $2.5 million and $5 million.
• The average utility construction company has estimated annual sales of $3.6 million.
• Approximately 75 percent of concrete construction companies generate annual revenues under $1 million; this is also true for HVAC, excavation, and plastering, drywall and insulation companies.
• Ninety-one percent of architectural firms and 84 percent of engineering firms generate less than $1 million in annual sales.

So, with all this competition among construction businesses, how can an owner make his or her company a more attractive and valuable investment over another? It all begins with a business valuation. Knowing the company’s value, as well as what drives its value, will empower and assist the owner in developing succinct and strategic value-enhancing plans to achieve business goals and build personal wealth.

What Is Business Value?

Many owners believe their company’s value comprises everything it owns minus everything it owes. Yet, business value encompasses much more. It includes not only tangibles, such as equipment and inventory; it also is driven by intangibles and goodwill, such as an experienced management team and the business’ outstanding reputation.

There are many reasons why an owner would need a business valuation, ranging from estate planning to a shareholder buyout, from acquisition of capital infusion to insurance and bonding. No matter what the purpose is, the determination of a company’s value should be performed by an experienced and credentialed third-party valuator.

All too often, owners are bewildered when they hear the unbiased value, especially if the owner wants to sell the business and the assessment is much lower than he hoped it would be. But there is good news. Knowing the business’ value, even when not considering selling, puts the owner in a position of control — control to make vital changes that drive value and eliminate factors that deteriorate value.

Quantifying a Company’s Value

Business value is commonly defined as fair market value. IRS Revenue Ruling 59-60 dictates various factors of fair market value for a privately held business. In general, fair market value is applied for taxation purposes. Although it isn’t a blanket standard used for every reason a business valuation is needed, one or more factors of fair market value are considered for practically every valuation engagement. Fair market value examines:

• The company’s history
• Economic and industry conditions
• The company’s financial condition and earnings capacity
• Goodwill and intangibles

Goodwill and intangibles are arguably two of the most important value drivers for privately held companies within the construction industry. However, determining the total value of a company can seem like a game of "Where’s Waldo?" if the valuator is inexperienced and doesn’t know where value drivers are found. Certainly, it is more involved than calculating net book value, or assets less the liabilities.

Twenty-plus years ago, this type of traditional asset accounting established 80 percent of the value of a company. Today, it constitutes only an estimated 25 percent. Why? Because traditional accounting performed typically by corporate CPAs overlooks many intangible assets. Historically, a contractor created its value with the tangibles it owned, such as buildings, property, equipment and inventory; however, to garner the highest price, today’s owner also must create value with intangibles. For a construction company, intangible assets include:

• Recognized name, slogan or phone number
• Contracts and clientele
• Human capital (e.g., experienced management and crews)
• Transferable licenses and certifications
• Proprietary processes, patents, copyrights or trademarks

As well as quantifying intangible assets, a business valuation can also quantify value derived from established operational history; successful bidding history; product and service diversification; established market share and reputation and repeat business. These goodwill factors, sometimes referred to as "blue sky," also enhance value and attract buyers. Conversely, litigation, union disputes, workers’ compensation claims, high employee turnover and bonding troubles deflate goodwill value.

Looks Can Be Deceiving

The amount of tangible assets a company will own varies among the different sectors of the construction industry and, therefore, the proportion of tangible asset value to total company value will also vary. For example, an excavation company owns large, expensive industrial equipment. A first blush at the company’s balance sheet gives a quick-and-dirty calculation of its tangible value, which may be a modest indicator of the company’s overall value.

Alternatively, a general contractor’s balance sheet can be a deceptive indicator of value. General contractors manage projects and usually do not own a lot of equipment or other substantial operating assets. Yet, that is not to say they don’t have value. A significant portion of a general contractor’s value may be comprised of intangible assets and goodwill built up over time.

Consequently, when selling the business, adding intangible asset value and goodwill means the difference between an attractive, lucrative investment and a profit to the seller, or an asset purchase and a breakeven or loss for the seller.

Buyer Beware

With valuation services, the age-old saying — "you get what you pay for" — is all too true. And just like a remodeling contractor wouldn’t be hired to do steel erection, it is highly recommended that a business owner engage only a credentialed valuation expert who has extensive experience valuing several different types of companies within the construction industry.

Although there are other professionals who provide business valuation services, such as CPAs, their valuation knowledge and experience may be very limited. CPAs who primarily prepare tax returns and financial statements may also be certified by one or more of the four recognized professional valuation associations. However, these individuals may perform only a handful of valuation engagements a year, which is grossly deficient to satisfy the experience test.

There are many CPAs who are certified and highly experienced, and who have chosen to make business valuation their full-time profession; these experts have next to no time to learn new tax forms or the latest family tax credit. The valuation profession has changed dramatically in recent years. Keeping abreast of current valuation theory, trends, financial reporting standards and relevant case law is a full-time job. In other words, valuation is not a hobby, nor is it a side job.

Erin Hollis, AVA, CVM, CBC, CM&AA, MBA, is director of valuation services for AAL, a company of IPA and IBA. For more information, call 847-495-6786 or visit www.ipa-c.com.