Construction Industry Insights Based on Recent Business Valuations
As part of a business valuation, the appraiser typically performs an in-depth industry analysis. The goal of the industry research is to understand the typical operations of the businesses in a specific industry, their risks, their prospects for growth, and other unique industry factors.
Drawing on several recent engagements in the construction industry, we introduce the construction industry structure and discuss several factors that differentiate construction companies from other types of businesses.
Construction industry structure
Construction companies range widely in size, from small sole proprietorships to large publicly traded corporations. Most construction contractors are small businesses. According to the U.S. Census Bureau, of the approximately 738,000 construction businesses in the U.S., 82% have under 10 employees and only 1% have over 500 employees.
The construction industry is also very diverse in terms of work performed. There are more than 30 industry codes that cover many types of construction under the North American Industrial Classification System (NAICS), which divides construction contractors into three main categories:
- Construction of Buildings (code 236). Includes both residential and nonresidential building construction. Residential construction includes single and multifamily housing. Nonresidential construction includes industrial building and commercial and institutional building construction.
- Heavy and Civil Engineering Construction (code 237). Includes utility infrastructure, roads, bridges, and other large structures.
- Specialty Trade Contractors (code 238). Perform many types of construction work including pouring concrete, structural steel, framing, masonry, windows, roofing, siding, electrical, plumbing, HVAC, drywall, insulation, painting, flooring, and others.
Additionally, construction contractors can be categorized into general contractors and subcontractors. General contractors are hired by the property owners or developers to manage the construction project. General contractors hire and supervise subcontractors, primarily specialized trade contractors, to perform most of the construction work required.
Types of contracts
Construction contractors enter into three main types of construction contracts: fixed price contracts, time and materials contracts, and unit price contracts. These contracts differ based on the way the contractor is paid and the amount of risk assumed by the contractor. The riskiest contract is the fixed price contract where the contractor is paid a lump sum and assumes the risk of completing the project in a profitable manner. The least risky contract is the time and materials contract. Additionally, the contracts can be categorized into short-term contracts that last a few months and long-term contracts that last a year or more.
Types of assets and liabilities
Construction contractors vary widely in terms of equipment they own. Heavy and civil construction contractors own large and expensive pieces of equipment, while general contractors can operate with lower levels of equipment expenditure and instead are able to rent large equipment such as cranes. Specialty trade contractors typically operate with minimal equipment.
The most valuable assets for a construction company may be intangible in nature and not be included on its balance sheet. Such assets may include, among others, the backlog of work on existing contracts, the ability and skill of the management team to bid and win work and manage the projects to complete them at a profit, and the relationships with customers, staff, and subcontractors.
Liabilities typically include interest-bearing debt commensurate with the amount of heavy equipment owned. Typically, the more equipment owned, the more debt. The construction industry is very litigious, as a result, at any given time, construction contractors are facing litigation contingent liabilities that may not be listed on their financial statements.
Unique accounting issues
The nature of the construction work also creates some unique accounting issues. Construction contractors have two accounts that are specific to the industry:
(1) Costs and estimated earnings in excess of billings (underbilling), and
(2) Billings in excess of costs and estimated earnings (overbillings).
Underbilling are presented on the balance sheet as a current asset, and overbillings are presented on the balance sheet as a current liability. For valuation purposes, the underbillings and overbillings are typically included in the working capital of the business.
For a premium, a surety company provides a surety bond to construction contractors for each project. A surety bond guarantees the project owner that the construction project will be done on time and according to the project specifications. There are three types of surety bonds: bid bonds, performance bonds, and payment bonds. To be able to participate in the bidding process, most contractors must post a bid bond. A performance bond protects the project owner in case the contractor fails to complete the project and provides funds to hire a new contractor. A payment bond guarantees that the contractor will pay the subcontractors.
Most construction contractors obtain work through competitive bidding. They submit bids on projects, and the best bid is selected. Sometimes the lowest bid is not necessarily the best bid. Other times, for instance for certain public works, the lowest bid is selected.
Accurate estimating is key
In a construction business, the estimator calculates the contractor’s cost for completing a construction project. If the cost estimates are too high, the contractor’s bid based on the estimates will be too high to win the work, and if they are too low, the contractor risks financial losses.
When valuing a construction company, it is important to understand several aspects of the business including the type of work performed, the type of contracts, the type of assets and liabilities, unique accounting issues, and unique operational issues such as bonding, estimating and competitive bidding. Once the appraiser gets a solid understanding of the industry and company-specific factors, he or she is ready to value the business.
See our article that discusses the valuation approaches and methods that are most applicable to construction companies.
Alina Niculita is a valuation and testifying expert who has specialized in business appraisal and appraisal review for litigation cases and business transactions for two decades. She has appraised hundreds of companies in diverse industries and sizes up to several billion dollars in revenue and testified in support of her opinions.