The Last Management Act: Selling Your Contracting Firm

October 1, 2011

Owners of contracting firms are all eventually faced with the inevitable. They will not be leaving this earth alive and breathing. Only astronauts do that consistently; but then, they return. At some point in their careers, contractors’ energy and attitude will wane. They will see that the business they built needs new leadership. Their bodies and minds tell them that the time has come to take on a different role in life.

When that time comes, what do they do about transferring ownership of their firms? That is often a difficult decision both intellectually and emotionally. Fortunately, several options are open to them.

Sometimes, it is just a matter of some legal paperwork giving ownership to a son or daughter with a family payout agreement. This is a common occurrence in the construction business.

On occasion, employees will step in as the new stockholders. Again, an agreement has to be sworn to and a cash payout schedule accepted by both parties. Such transactions, as long as there is a talented core group that owns the majority of stock, can give the company a new life and a thriving existence for many years.

The most complicated and daunting option is the third party buy/sell agreement. In many cases, the buyer and seller will not personally know each other beforehand. This leads to a longer transaction process with an unpredictable ending.

In all these examples, the owner’s goal must be to accomplish two things:

  • Change his/her relationship to the firm
  • Derive some monetary value for the firm.

The transaction between the former and new owner(s) will be unique. Each of the parties in any buying/selling situation will have unique sets of circumstances and needs.

As stated before, emotions are part of the equation. The owner who has spent many years nurturing the firm now has to say goodbye. As you know, this not an easy transition.
A majority of proposed transactions do not go through because of this very reason.

To address this issue, the selling party needs to think about this life change and what he or she will do in the future. Having a specific plan for particular activities to fill the time is more beneficial to making the transition than just thinking about “enjoying retirement.”

Once the seller achieves a comfort level with the idea of divestment, then the next hurdle is to think through the transaction from both the seller’s and acquiring party’s perspectives. All contractors have a fairly clear idea of what they want to happen. However, the buyer’s perspective is just as important for the seller to keep in mind. Ask yourself, “What would I want or accept if I were buying a contracting firm?” Keeping a balanced perspective in your approach to the negotiation will not kill it prematurely.

Do understand that construction firms do not sell at a premium. While in some rare cases they may be valued at as much as four times earnings (plus the value of the firm’s assets), most firms are typically valued at no more than two times earnings. Sadly, this is not a great amount of money. As you can guess, if financial concerns are your top priority, then keeping your construction firm until you die makes the most sense. But if your goal is not a strictly a financial one, then selling your firm may be the best move, as some of the best benefits cannot be valued in dollars.

Contractors buy contracting firms. A majority of transactions occur between like professionals. Yes, sometimes there is the one-off transaction far afield. Money management firms and public utilities have purchased construction companies. However, these are rare cases. In essence, only contractors want to be in this business—some say 9 out of 10. Hence, the search for a buyer is more efficient if pursued within the population of contractors.

The Process

  1. Gather Data
    • Tax returns
    • Financial statements
    • Closed job information
    • Organizational chart
    • Loan agreements
    • Employment contracts
    • Other important documents, such as any legal settlements and supplier agreements
  2. Conduct Interviews

    The business broker will interview the owner(s) after studying the corporate information. This needs to be accomplished so the broker knows all circumstances surrounding the company and can answer them for a prospective buyer.

  3. Assemble Contact List
    The business broker will assemble a potential buyer list. The owner(s) will review the list, cross off those people who are objectionable, and add people he or she may know.
  4. Make Contacts
    Typically, formal letters will be sent to individuals who have been identified as potential candidates. The letters have a sales flavor to them and describe the company and its situation in general terms so there can be little chance of someone guessing which firm it might be. After the letters are sent, follow-up phone calls are made to generate interest.
  5. Confidentiality and Non-Disclosure Agreements

    Once interest is signaled by one or more potential buyers, formal documents are drawn up, including the interested party’s pledge not to disclose or otherwise disseminate your company information, including the fact that it is for sale. A good agreement will have remedies for violations. The remedies can be financial penalties.

  6. Send Company “Book” of Information to Potential Buyer
    The book of information will be created by the business broker. It will disclose the details of the business, its financial status, market share, organization structure, and labor situation, among dozens of other areas. The buyer should be able to decide whether the company is of interest based on the data provided. If not, the book should be returned.
  7. Face-to-Face Meeting between the Seller and Potential Buyer
    This meeting is crucial to establish a working relationship and to see whether the chemistry is right between the parties. Sometimes this is the last meeting between the two and the transaction dies. If both parties feel there is a value to going further, additional meeting(s) will be held.
  8. Potential Buyer Issues Letter of Interest
    Once a letter of interest is sent to the seller, some steps occur in rapid succession.
  9. Due Diligence
    Buyer will have 60 to 90 days to inspect the business being purchased. They will go through the books, see the fixed assets, look over the projects, etc.
  10. Create Purchase Agreement
    The parties will create a purchase agreement that spells out in great detail what is being bought, under what conditions it is being bought, and at what amount it is being bought.
  11. Set a Closing Date/Hold the Closing
    The business broker, the seller, and the buyer will set a closing date that is fairly close in time—90 to 120 days—from the date of the Letter of Interest.

Types of Buyers

There are three types of buyers. You should be aware of each type’s goals and focus:

  • Strategic buyer
  • Economic buyer
  • Familial buyer

A strategic buyer is someone looking for geographic or service expansion. They can be looking in your state. People from the north sometimes buy a firm in the south. Alternatively, a buyer could be looking for a business to expand their service offering. A plumbing firm may purchase an HVAC contractor. Suffice it to say, there are numerous possibilities.

An economic buyer is looking for good price for the value received. The potential buyer might speculate that they can buy the firm at X and hope that it will be worth 2X in a couple of years. They will sometimes purchase a firm in financial trouble to capture its work force. As you know, journeymen are not easy to grow.

A familial buyer is someone who knows the owner through a family relationship or is an employee(s) of the company. (Company employees are often considered an informal family.) This kind of transaction is a good first option. There always seems to be more comfort on both sides with this situation. People know each other well and the payment terms are friendlier. Trust is typically high.

The Value of Your Firm

The value of a construction firm is fairly simple: a multiple of the predictable income stream plus the value of the assets.

Ascertaining and agreeing on a predicable income stream can be difficult, historical performance notwithstanding. A commercial or industrial contractor’s worth is based on several factors, including bids and present and future work in process. A residential builder might be based on inventory, name recognition, product, and economic factors. A service contracting firm is more straightforward, since the business acts more predictably.

A common mistake is to believe that an abnormally great year can be used as the basis for value. It should not be. An average over several fiscal years should be used. Another mistake is to presume that the real estate you own for your construction operations is worth a premium price. Again, think of what you would want to pay if you were the buyer.

The market determines the multiple and the value of the assets. The last few years of closed transactions are a good basis for valuations. Certified professionals in this area are the only ones who can ascertain the fair market price. In some cases, each party will hire its own business appraiser and then negotiate with the other with its report in hand.

The owner has a range of working options after the sale. Some, who obviously know more than anyone else about the firm, stay involved as the leader for a period of time. This gives a smoother transition to the new owner, who will need to become familiar with the business.

The other end of the spectrum of options is for the exiting owner to completely leave the business as soon as the sale is complete. As you might guess, there has to be some transition period, but in this scenario, the transition time is brief.

The seller should expect to be compensated for time spent working with the new leader(s). If the previous owner stays on as a senior manager, then an “earn out” is formulated. Typically, it contains salary plus bonus, the bonus being a percentage of profits, typically gross margin.

Some Traps

  • It is estimated that a majority of all proposed transactions do not go through. There are several reasons for this, and they are not surprising.
    • An owner feels the company is of greater value than the market will bear.
    • The candidate company has no second-in-command to take over. The new owner most often has no one to come in and take charge. They are looking to the company for leadership. If there is none, the risk is too great to the purchaser.
    • There is a “profit fade” between the initial
      contact campaign and the closing date. Some owners start leaving the business mentally and the financial statement shows it.
  • An estimated 80 percent of the transactions that do go through are sales to employees or family members. Neither of these can make a cash payment for the business, so a payment plan must be formulated. This means the acquirer will be using your future profits to buy your business. If they fail, you may get your business back.

One caveat to anyone considering selling their firm: There is no such thing as “retirement.” Understand you must be intellectually engaged in something. To not do so decreases your chance at a long post-contracting life. Additionally, if you talk to others who have sold their companies, you will find that there is certain happiness in doing something challenging or rewarding.

Make no mistake: a construction contracting firm is difficult to sell. It takes several factors to come together simultaneously. Most importantly, the two sides must be willing to negotiate and be reasonable in their demands. Other factors that complicate the matter are valuation, economic forecasts, business performance, and the regulatory environment. Bottom line: if the two interests want to, they can make the transaction happen.