Understanding Your Business Valuation

An accurate business valuation depends on honesty and a lack of bias.

A construction business valuation is often an eye-opening and emotional experience. Owners can be disappointed when valuators underestimate their companies. Unfortunately, many owners do not understand that fair market value is quite different from strategic value.

A ruling by the Internal Revenue Service defines fair market value as “the price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.” 

Legitimate business valuations focus on the last statement, in which a valuation expert must resolve competing motives and contradictory perceptions between both parties in order to determine fair-market value. 

Reasons to Consider a Valuation

A credible valuation of your business can equip you to move quickly in response to marketplace opportunities and challenges. Yet considering the reality check that a proper valuation delivers, many owners perceive the process much like a root canal—not to be pursued unless absolutely needed.  In reality, many situations demand a business valuation.

• Strategy—management planning, a buy or sell opportunity, financing and banking requirements or tax planning.
• Litigation—economic damages, lost profits, or owner disputes like bankruptcy, shareholder dispute and divorce.
• Finance—fairness opinions, employee stock option plans, purchase price allocations, goodwill impairment tests or debt covenant compliance.

The Income Approach

For the construction industry, the most commonly used approach for a valuation is the income approach. This approach predicts future cash flow and discounts it back to present value using a discount rate that reflects your company’s risk compared to alternative investments.  

The other two approaches—the market approach and the asset approach—are not used as frequently for valuing construction businesses. The market approach uses historical data from comparable transactions operating in the same market space (from either publicly traded or privately held businesses) and serves as a reasonableness check. The asset approach uses the familiar cost approach, essentially marking up a company’s assets and liabilities to fair market value and subtracting the difference. This means that the asset approach is usually reserved for companies with lots of tangible/fixed assets.

The Valuation Process

Your business’s cash flow is of utmost importance to an accurate valuation. At the start of a valuation process, you will be asked to provide income and cash flow statements, balance sheets and projections.  Even if your company’s books are virtually audit-ready, a valuation expert will likely need to examine any summary information and scrub items such as your receivables, equipment, pending litigation, contract backlogs and more. The credibility of contract backlogs and projections is critical for many construction companies during their valuations.

You will also be asked to respond to a management questionnaire or participate in a management interview. Some owners find this process invasive, as they have rarely shared confidential information or had their business decisions scrutinized. In reality, the qualitative assessment of your company is the most important part of the valuation process. The valuation analysis will only be as good as the underlying data that goes into it, both from the initial document check and the interview.

Any credible valuation expert will require access to prior valuations. Owners are often tempted to manage value based on personal or professional motives that ultimately change over time. Past inaccurate valuations, albeit favorable at the time of their use, can haunt an owner years later when it comes time for another valuation. A wide range of values over time may illustrate an owner’s failure to take the business valuation process seriously and diminish a current valuation’s credibility. The best motive for any valuation should be a desire for an accurate report that fairly reflects your business’s fair market value as of the date of valuation.

Quality Providers

To obtain an accurate valuation for your construction business, find a credentialed and experienced valuation expert. Ask your CPA firm if it employs an accredited valuation expert. If they do not, ask for a referral. Every CPA firm needs valuations for estate and gift tax returns.  You can also go straight to the organizations that train and accredit business valuation experts. The American Society of Appraisers, American Institute of Certified Public Accountants and The Institute of Business Appraisers all have websites with search functions for business valuation appraisers in your area.

The most important participant in the business valuation process is ultimately the business owner. Nobody knows your business better than you. Working with your business valuation appraiser will be a rewarding experience, as it often leads to changes you can make to achieve your ultimate goal—increasing the value of your business.