By Stuart Phoenix
Creating value and goodwill above accumulated earnings value requires more than making money; it requires building an organization that makes money with or without the owner.
Value creation is a rational goal of any business owner. Eventually when the time comes for the business owner to sell, the potential buyer’s assessment of the value created may not coincide with the seller’s. Some of the differences between the seller’s and buyer’s opinion of value can be explained by human nature; however, in the engineering and construction industry, many of the differences can often be found in how the business owner went about creating value in his business.
A business owner can go about creating value by:
1. Accumulation of earnings
2. Growth in earnings
3. Creation of goodwill
Accumulation of Earnings
Using the “accumulation of earnings” method, the business owner makes as much money as possible, but without creating an enterprise that is salable for more than its asset value.
Most engineering and construction firms fall into the “accumulation of earnings” category — particularly smaller firms. The business goal is to make money, and the owners realize the earnings of the firm by distributing earnings, eventually selling the business for its book value (retained earning value), and perhaps an earn out based on future earnings, or even liquidating the firm.
Goodwill (in the financial sense) is not created, and the business does not have a value that is separate from the assets and liabilities it accumulates.
Growth in Earnings
Alternatively, using the “growth in earnings” method, the business owner creates the business so that the value of the business is tied to its earnings capacity, knowing that eventually there will be a buyer who will pay some multiple of earnings for the business.
A company that uses the “growth in earnings” method might be worth three to five times its pretax earnings and, through various strategies, earnings are grown. Then the increased earnings are multiplied by the same three to five multiple. Therefore, the value created is by the increase in earnings, not by an increase in multiple.
Creation of Goodwill
The creation of goodwill method includes the “growth in earnings” method, as goodwill is, by definition, the value of a business above its asset value. For our discussion, the “creation of goodwill” method is defined as creating value by making the unsalable company salable; making the company that would sell for book or asset value sell for a premium to book; or making the company that sells for a multiple of earnings sell for a higher multiple.
Not Many Engineering and Construction Companies Create Goodwill
Empirical statistics cited for companies of all sizes in the engineering and construction industry show that 30% of companies will eventually liquidate. Approximately 60% will eventually sell or transfer to family or employees. Approximately 10% will sell to a third party.
Companies that liquidate create value by accumulating earnings. Companies that sell or transfer to family or employees mostly create value for their owner by accumulating earnings, though some may realize a premium to book as with the other two methods. Sale to a third party could be at asset value or greater. Again, it could use any of the three methods.
The implication of these statistics is that not many engineering and construction companies create goodwill; though most accumulate earnings. The reasoning behind this may have something to do with the fundamentals of the construction industry, such as:
The engineering and construction industry is fragmented because:
• Most building markets are local.
• There are limited economies of scale.
Purchasing advantages for engineering and construction vary widely, as suppliers will often support the local business to avoid being too dependent on the national or regional business.
The effect of fragmentation is that the locally owned and managed business will often out-compete the division of a national or regional firm run by a division manager.
Market opportunities come in waves. Five years is an eternity in the construction business, and what is built over time is cyclical. Successful firms are able to move fast with the waves of construction activity and are flexible enough to grow smaller or larger when needed.
Businesses often struggle in downturns because of reduced margins. In addition, banks and sureties, that are often supportive in up markets, turn away from engineering and construction firms in down markets.
About every 10 years, something happens, often external to the engineering and construction industry, that negatively affects the construction markets. Some examples are the oil embargo in the 1970s, interest rates peaking at more than 20% in the 1980s, the savings and loan crisis of the 1990s, the World Trade Center attack and bank collapses in the 2000s.
Each of these events caused dramatic downturns in construction, often confounding the best efforts of industry entrepreneurs in value creation and consolidation. The result was the failure of many of the larger firms in the industry.
All of these factors make value creation, beyond accumulation of earnings, difficult for the engineering and construction firm. Growth by diversifying into somebody else’s geographical market creates added competition with locally owned businesses. Growth by diversifying into a new type of construction runs the risk of getting into the market at the wrong time, and facing competition in an unfamiliar market. Investing in an acquisition strategy to consolidate a market runs the risks of the market turning down, struggling to integrate an acquired company, paying too much to an unmotivated seller, or paying too much to a seller in the midst of an industry consolidation wave.
Owners of private companies often acknowledge the difficulty in creating goodwill in their buy/sell or stockholder agreements by using book value or asset value for their valuation. This may be a deliberate avoidance of including any goodwill in the business valuation. Or it may represent conservatism, or just a desire to keep the valuation methodology simple by using the results of the balance sheet prepared by the accountant or an appraisal of assets.
With this thinking as a backdrop, how does an engineering and construction firm create goodwill? That is, a business which a buyer will purchase at a value beyond its assets and accumulated earnings value? The drivers that create goodwill in this industry are:
A leadership culture. A construction firm is a group of people who get, perform, and are paid for the projects and services they provide. Take out the people, and truly all you have are the assets and liabilities of the business. A leadership culture is one that develops exceptional people, and the business is therefore able to grow by expanding the organization.
An ability to find and exploit opportunities. The slow-growth and cyclical engineering and construction market is made up of numerous construction markets that cycle with intensity. Profit margins in sectors vary widely as well. The value-creating firm is able to quickly find and move to and from opportunities.
Financial discipline. In the article “Why Contractors Fail”, an interesting finding was that, while the nature of the industry and the economy were contributing factors to failure, the primary reasons were poor strategic decisions or lack of financial discipline that led to capital erosion. Bad things are going to happen to businesses in this industry, and there is no substitute for a strong balance sheet and the financial discipline to enable a business to go after the next set of opportunities.
Taken together, these three drivers can create value in the buyer’s mind:
The first driver provides the potential buyer with the confidence that there will be the best leaders and organization to facilitate growth, in contrast to many businesses where the selling owner is the sole driving force in the business.
The second driver provides the potential buyer with the confidence that the business will be able to enter and exit markets when the company’s current market cycles, compared to a business that has been successful only in a single service, market sector or geographic market.
The third driver can create greater value to the buyer because the business has financial systems and controls in place to identify problems and opportunities early, and the decision-making skills to react appropriately.
Ownership Structure for Value Creation
To realize goodwill in the valuation of a business also requires adopting an ownership structure to exploit opportunity. Exhibit 2 shows five ownership structures. First is the private structure. This is the least likely structure to result in payment for goodwill. In fact, goodwill in a valuation for a business’s private ownership structure may work against the survival of the business as a private firm. Why? If the stock price is too high, a sale to employees or back to the company may put financial strain on the business, leading to a loss of financial discipline and capacity.
The other four ownership structures — private equity, strategic sale, public IPO/SPAC and ESOP — all offer the opportunity for a valuation and sale of stock at a value that includes goodwill.
Private equity is a pool of funds provided by investors that is managed and invested by a management firm. The investors in private equity typically include high-net-worth individuals, endowments and pension funds. There are thousands of private equity funds investing pools of money in all types of businesses. A segment of these funds invests in engineering and construction firms.
Private equity provides two opportunities for a seller to realize value from its business. First, if a business meets its investment criteria, the private equity fund will pay a multiple of earnings or cash flow for a portion of the business. Typically, it will not buy 100% of your business. If this occurs, private equity managers will then encourage and possibly help the business increase its value by increasing earnings, making the business more salable.
Another opportunity for the seller to realize value can be derived from a second sale, typically three to seven years after the first purchase, wherein both the current private equity fund and the participating managers realize capital gains. Private equity is very selective about where it will invest. It likely will pay for goodwill in a purchase and its hope and intent are to increase dramatically the goodwill realized in the second sale.
In a strategic sale, a business sells to a third-party buyer, such as a larger private company, public company or a private-equity-backed company. Value is driven by the profitability of the business, its asset base, as well as intangible and strategic factors. Buyers have their own motives and interests for an acquisition, and this will drive their view of value. Strategic purchasers may seek to enter new markets, consolidate a market, build out a national footprint, or a host of other strategic intentions. Ultimately, value is negotiated between buyer and seller based on both parties’ interests and motives.
An Initial Public Offering (IPO) is a process whereby a business can sell a portion of its stock to the public. The public, as defined here, includes institutional and individual investors. After the IPO, the stock of the business trades on an exchange. Value is driven by the underlying fundamentals of the business, industry and market trends, and comparable stocks within the same industry.
Determining Goodwill Value
Opening up your business to the market is the ultimate test for the creation of goodwill. However, many owners do not test the market to see if a buyer will recognize their value, as they prefer to remain independent. Many engineering and construction business owners, toward the end of their careers, are disappointed when they discover that the value of their business is tied more to its asset value or a nominal multiple of earnings than to any goodwill they assumed had been created. It is often difficult to explain to these owners that their notion of goodwill does not hold in a buyer’s mind — because the goodwill is overly dependent upon the selling owner as a person. Also, the buyer could see risk where the owner sees opportunity, and therefore, the buyer’s valuation is tempered.
To create value and goodwill above accumulated earnings requires more than making money; it requires building an organization that makes money with or without the owner. It requires a corporate culture that is continuously developing people to expand the capabilities of the organization. It requires a corporate culture that is forever in search of new opportunities in the industry; one that has the ability to take advantage of those opportunities. The organizations that can build the culture of developing their people, and create processes to constantly identify and exploit new opportunities, are those that are most likely to create value and goodwill.
Stuart Phoenix is a principal with FMI Corporation. He may be reached at 919.785.9241 or via e-mail at email@example.com.
Rice, Hugh. Why Contractors Fail. FMI Quarterly, 2006 (4), p. 6‒8.
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