In Part One, the basic acquisition concepts of motive and due diligence were discussed as well as the first two of the seven shades of gray: (1) Union labor agreements; and (2) Percent complete for current projects. In Part Two, the remaining five critical considerations that a foreign company should properly investigate prior to purchasing a U.S. construction company will be discussed.
Knowing And Understanding The Estimating Process
Construction companies often have their own estimating processes and formulas that they believe give them a competitive advantage. While the components and estimating processes often look the same, nuances exist and must be fully understood and vetted to properly determine the risks of newly awarded or recently commenced projects. As strange as it may seem to an attorney or an accountant, estimating is a process that tends to be deeply personal to each construction company and is often considered proprietary or a trade secret. While many sophisticated construction companies utilize pre-packaged estimating software, they often customize it to meet the company’s needs and culture.
For example, production costs for self-performed work are often developed through tracking historical information collected on projects with similar structural or architectural components. The cost per cubic yard for the placement of concrete in column formwork that is utilized in an estimate for future self-performed work may be developed from the analysis of the cost per cubic yard for the placement of concrete in column formwork on four similar projects that the contractor has completed. How these production rates were developed (which includes how the prior projects used in the development of the production rates were selected – random or specifically chosen based on common attributes) is important to consider and understand when valuing the company and the overall worth assigned to the backlog of work. Expressed another way, if the production rates for all self-performed work are not the result of proper analysis, then those rates will likely not be accurate and could result in actual costs that exceed the estimated costs. This differential is typically not recoverable from an owner in a lump sum contract unless the owner’s actions caused the differential. Accordingly, the strength of the target company’s current backlog may not be as black and white as the target company would like the acquiring company to believe.
Similarly, if the target company is currently engaging in the construction of unique buildings or in sectors (building, highway, institutional, manufacturing, etc.) for which the target company has no historical perspective, the purchasing company should consider whether a full-blown audit of some of those projects is appropriate. In some cases, the only way the acquiring company can gain any comfort in whether these unique projects are more likely to drag down or add to the company’s future profits is to perform such an audit.
Revenue Claimed Against Change Orders
The practice of claiming revenue for anticipated owner-initiated Change Orders is a process that, while perhaps not a new concept to all foreign companies, can differ wildly amongst construction companies. To begin with, Change Orders are a common component of every construction project. And, unfortunately, in the U.S., disputes over the amounts owed for owner-initiated changes tend to happen more often than contractors would like. Such disputes are harder to resolve, and the value of the changes harder to quantify, when the contractor and owner have very different ideas of what the original contract included versus what portion of the scope in the owner-initiated change falls outside the original contract. Further, even when the scope or magnitude of the change is agreed upon, final resolution can be difficult to reach because of fundamentally different ideas between the owner and the contractor about the value of the added or deleted work and its impact (if any) on the project duration. If the scope of an owner-initiated change causes an increase in the project duration, the result can be additional direct and indirect costs for the changed work.
Despite the inherent uncertainties over the values of owner-initiated changes, it is not uncommon for construction companies to treat the anticipated value of the changes as expected revenue in the form of an adjustment to the remaining contract balance on a project. The purchasing company’s Due Diligence Team should closely evaluate all outstanding changes, the contractor’s pricing of those changes, the history of the changes, and the status of negotiations with the owner for payment for changed work on the project. If there is a large, pending, owner-initiated Change Order for which the owner has refused to pay and resolution has been delayed, the purchasing company should evaluate the risk that the amount requested will not be paid by the owner. Taking the time to probe these issues, and removing such sums from expected revenue numbers if warranted, can alter the overall valuation of the target company to the benefit of the acquiring entity.
Revenue Claimed Against Claims
Similar to claiming owner-initiated changes as revenue, some U.S. contractors also include the value of pending claims against an owner in their reported revenue or adjusted contract amounts. Like expected revenues on pending Change Orders, treating claims as revenue and identifying the true value (if any) is a slippery process. When considering claims, however, the legal hurdles to recovery and the costs of pursuing the claim must be considered in addition to accurately determining the claim’s merit and value. Such expenditures are unlikely to be considered by the target company as a future expense against the expected claim revenue.
Further, excessive reliance on yearly financial statement audit letters subject to the Financial Accounting Standards sent by the target company’s legal counsel to the auditors is dangerous. Such letters rarely give black and white answers and instead tend to provide gray statements about the recoverability of claims. Specifically, statements as to the value of pending claims (or the value of threatened claims) are more often than not based on numerous caveats (they are written by attorneys, after all) and rarely if ever address the most important question: collectability. At the end of the day, to recognize revenue on a claim, a company must be able to collect on the judgment or award. The Due Diligence Team should give careful consideration to this issue when determining how much, if any, revenue on pending claims should be included in the valuation and pricing of the target company. Outside claims litigation counsel and outside consultants can be a valuable asset for this due diligence task.
Exposure To Unstated Claims
The pending or threatened claims by owners and subcontractors are often easy to identify. Using the same process discussed for affirmative claims above, the Due Diligence Team can analyze and quantify the likely risk associated with these known claims. What is more difficult (and sometimes impossible) to predict and quantify is the ability of lower tier parties to bring claims on bonds or the ability of subcontractors to come back years after project completion to pursue claims for additional compensation. On public works projects (and for some private projects), the requirement of a payment bond can expose the target company to claims from lower tier subcontractors for which no direct contract exists. The same dilemma exists for laborers and trust funds for union employees.
The potential for these claims exists despite indication of full payment to the first-tier subcontractor. If appropriate releases have not been obtained, the acquiring company could be surprised by a subsequent bond claim. For this reason, it is important to discuss and consider how such unstated claims will be dealt with and what responsibility is being assumed for apparently completed projects that still have liability tails associated with required bonds.
In addition, if the target company is, or has been engaged in significant public works projects, the Due Diligence Team should be aware that public owners in some states are not subject to the applicable statute of limitations or statute of repose. While this is a state by state issue, for those states in which it is applicable, the ability for an owner to come back more than ten years after construction to pursue claims for defects or breach is a risk that must be factored in when setting the reasonable purchase price. Further, it places an emphasis on examining the past insurance policies for the target company and gaining an adequate comfort level with the amount of insurance coverage available per occurrence and the remaining available aggregate limits.
Key Employee Retention
Employees can be compensated in many different ways. To some employees, the weekly or bi-weekly paycheck is enough to keep them happy. To others, the amount of deferred compensation offered by a company in the form of stock, S-units, 401(k) deposits, profit-sharing, or bonuses may be important to their happiness. If the purchasing company intends to convert a target company away from employee ownership, for example, this could have a significant effect on the retention of key owners/employees who have made valuable contributions to the past success of the target company. The loss of key personnel can not only undermine the overall foundation of the target company, but can also resonate with project owners so that the perceived advantages to be achieved by the company purchase in terms of gaining market share are eroded. Typically, this problem is more likely to develop with a mid-size regional construction company that is employee-owned and has established deep connection with the local players in the market. Loss of such key owners (who have now become employees) can result in the anticipated market share dwindling, undermining the original motive for the purchase.
While the above issues represent only a handful of the pitfalls that must be probed when acquiring a U.S. construction company, they all demonstrate that the key to any successful due diligence review will depend on the willingness and ability of the Due Diligence Team to go deeper than they might otherwise think is necessary and question the assumptions and practices of the target company that serve as the foundation of the target’s revenue and backlog of work. Understanding the goal of the acquisition, accepting that industry norms and practices can vary from country to country (and in the U.S. by geographical regions), and looking to outside people to fill out the roles on the Due Diligence Team can make the difference between long-term satisfaction with an acquisition or a bad case of buyer’s remorse.
This article was first published in the IPBA Journal March 2013 Edition and has been reproduced with the permission of the IPBA.