By Brad Eriksen
Homebuilding has yet to recover, commercial construction projects seem at a standstill (with the notable exception of Intel), and many public infrastructure projects appear about to fall victim to the budgetary axe. This uncertainty in the design and construction industry has had a significant impact on succession planning for the business owner who thought retirement was just a few years away. This uncertainty affects valuation models, the ability to finance transactions, and the willingness of the next generation of owners and managers to step up and take responsibility for the future success of the company. How does the business owner in the design and construction industry plan for the future transfer and succession of the business with all this uncertainty? Very carefully.
While the valuation of any business is a complex and imprecise exercise, a few rules of thumb have provided business owners with a general idea of the value of the business. Whether that rule of thumb was a multiple of Earnings Before Interest, Taxes, Depreciation, and Amortization ("EBITDA"), a formula based on book value, or some other methodology, rough approximations of the value of the company were possible. But the current economic uncertainty has had a depressing impact on many company valuations. During the recent recession, valuations have taken a hit. Companies that would have sold for a 5 or 6 multiple of EBITDA are now valued at a 4 or 5 multiple. The book value of many companies decreased as revenues shrank. But there was some recovery during 2010, with EBITDA multiples returning to historic levels and book values increasing as revenues stabilized.
This year, 2011, has brought renewed concern as to the continued profitability of many companies. Valuations have softened, with EBITDA multiples again moving down and balance sheets contracting. While this may provide buying opportunities for companies seeking to expand, for those company owners that intended to use proceeds from the sale of the company to help finance retirement, retirement may be deferred for a few more years, and expectations of a retirement lifestyle may need to be adjusted.
With economic uncertainty comes difficulty with financing. Institutional lenders are requiring potential buyers to surrender ever larger amounts as down payments, limiting potential buyers to those with the strongest financial position. Seller financing is making a strong comeback, but this creates additional risks and uncertainty for the selling business owner. Structuring and securing the transaction so that the seller is assured of getting paid the full purchase price over the next few years can itself put the future success of the business at risk by restricting the buyer's ability to obtain additional working capital for the business.
Private equity buyers have the funds available to finance the acquisition, but many private equity deals are structured with a portion of the purchase price as an "earn-out," so that a portion of the risk of the future financial success of the company stays with the selling business owner.
Typically, potential buyers for the business included key employees, family members, and outside third parties, either in the industry or with private equity firms. As already noted, the current financial uncertainty has further limited potential buyers.
Most notable is the unwillingness or financial inability of key employees to assume the responsibilities of ownership. Having experienced firsthand the recent financial reversals of the company, many key employees are not willing to put their nest eggs at risk to acquire the business. Similarly, earn-outs or bootstrap acquisitions, where the purchase price is paid from the future earnings of the company, do not seem a good bet because future earnings and profits are problematic at best.
The same is true for many family members of the company owners. Having seen the stress created during financial downturns, family members may be unwilling to take on the responsibilities of ownership, and often the senior generation actively encourages the junior generation to explore careers outside of the family business.
With valuations lower and key employees and family members reluctant to make the commitment, industry competitors and private equity firms are taking advantage of the buying opportunities. Industry competitors seeking to increase market share or expand geographically are buying up smaller competitors. Private equity firms, with money that needs to be put to work, are also entering the market. Both realize, however, that it is a buyer's market and are driving hard bargains.
All of this is not to say that now is not an appropriate time to do some serious succession planning. Tax rates are at relatively low levels and appear to be headed higher. Lower valuations can be a benefit for intergenerational estate planning. And there are always buyers out there for a well-run, profitable business.