OP-ED: A 2018 Problem: Succession Planning Amid a Hot Market
The construction industry remains Oregon’s fastest-growing sector, expanding by nearly 10 percent this past year. That growth rate is more than double the rates of the next fastest categories: transportation, warehousing and utilities. Several surveys and reports forecast that growth is expected to continue.
So, why is this positive outlook a problem for the construction industry? Because a hot market is one of several triggers of ownership transition for construction, and many companies have not planned for it. A robust market acts as a trigger as consolidations and valuation multiples become common talk in the marketplace. Owners perceive their company values going up. Acquirers assess where those companies are in the business cycle. Everyone in the cyclical construction industry understands the sector may soften ahead of the cycle. So the questions become:
- Is the timing right for this construction business to sell to a third party or to management?
- Will the owners get the most value?
Both of these questions depend on whether the company is “deal ready.” Timing is critical for most transactions because the window can be tight and readiness takes time. If the company has not planned for a business transition, it may miss the opportunity – especially if it has not planned because of the owner’s age and a lack of internal management succession status. Those are two other triggers for transition.
Most contracting companies’ value is in their hard assets, their ability to retain talented employees, their customer base and contracts, and their reputation. There is also added value if the contractor is in a specialty niche or has a strong geographic presence. However, the main value detractors are liabilities and debts, dependence on the owner and unpredictable future prospects.
Failure to plan ahead can leave a construction business in a bad situation if the owner wants to sell or is approached for a transaction and is not deal ready. Fewer than 20 percent of businesses for sale actually close. In the construction industry, the closing rate for outside sales is even less unless the selling company is in a unique niche or location, or the economy is just right.
Consider these tips for being deal ready:
Documentation and due diligence
The process of due diligence will reveal whether a company has planned to get the most value or whether there will be a corresponding impact on price or a failed transaction. For example, the failure to properly document the customer and employment relationships can haunt a seller in due diligence. Another common issue is when construction permits or licenses are held by the wrong individuals; then permitting becomes an issue. An additional issue is when the owner has personally guaranteed agreements or surety funding that could have been limited by time or amount if a transaction was expected. These items, and the lack of other housekeeping or preparation, can lead to the loss of real value as a potential buyer negotiates to lower the price or, alternatively, tries to circumvent the owners and go directly to the customers and employees without dealing with the owner. Remember, handshakes may be good for introductions, but they are not enough to document and protect value. This item becomes one of the detractors for unpredictable future prospects.
Knowing the goal
Planning allows the owner freedom to negotiate and set the terms of the transaction because the owner is prepared, knows the goal and has a backup plan. For example, if the owner has a succession plan and knows how much cash is needed both for personal and business needs, the owner can negotiate an earn-out or other deferred purchase price option without taking on risk due to time delays or the possibility of never getting that consideration. Alternatively, the business can walk from a transaction without investing expensive time and resources as it knows what it wants and needs and can continue with its ongoing plans.
Understanding historical liabilities
Historical liabilities can be a major negotiation point in construction industry transactions. Some of these concerns can be addressed up front with ongoing planning and proper contract documentation. These tools allow for limits on liability that are well defined and insurable and provide the owner and the acquirer with certainty about possible trailing liabilities from prior projects. This item can be a detractor as it affects liabilities.
Retaining the talented employees
Planning will give the business time to develop and document a culture of commitment to retain talented and skilled employees. One of the keys to a successful transaction is that internal management succession is in place. This item can be a detractor as it shows dependence on the owner and it may impact reputation.
Planning for taxes and estate planning
Lastly, planning will allow for efficient tax and estate planning. Not losing value to taxes is important for retirement and not outliving the money. Like many private companies, contractors hold more than 70 percent of their wealth in their businesses.
In summary, while the market may be hot, transition still requires special planning for a construction industry business.
Column first appeared in the Daily Journal of Commerce on June 26, 2018.