By Michael French, CPA, ABV, CFE, Managing Director
Due diligence leading to a merger involving construction companies involves special consideration of issues unique to the industry. During times of high investment activity in construction deals – such as what we’ve seen in the past couple of years – investors must understand how the singular characteristics of a construction company can impact not only deal value but the potential for profitability down the line.
The following are seven items that should be included in M&A due diligence to achieve a successful merger in the construction industry:
Revenue Recognition
GAAP requires revenue associated with long-term contracts to be recognized as performance obligations are met, and many construction companies use the percentage-of-completion method. It’s essential to confirm that the merging company understands how to properly execute the percentage-of-completion method of accounting. Because the percentage-of-completion method relies on management estimates, management’s estimating ability and how that impacts the financials must be examined.
Working Capital and Indebtedness
Treatment of underbillings and overbillings can vary from one company to another. If the company is overbilled and presents negative working capital on a cash-free, debt-free basis, a buyer may want to consider overbillings to be treated as indebtedness. If this is part of the company’s normal cash conversion cycle, a seller may be able to argue that overbillings are a part of net working capital. These different approaches can significantly impact the net purchase price.
Schedule of Contract Activity
The schedule of contract activity is used under the percentage-of-completion method to calculate revenue recognized for the period. The schedule should include the following for all contracts completed during the period and all contracts in progress:
- Budgeted total contract revenues and costs
- Prior period(s) actual revenues recognized and costs incurred
- Current period actual revenues recognized and costs incurred
- Estimated costs to complete the project work
- Progress billings since the beginning of the project work
- Calculation of project overbillings or underbillings
Backlog
Backlog is the amount of revenues a construction business owner expects to recognize from remaining work to be performed on uncompleted executed contracts, including new contract agreements for which work has yet to begin. It basically represents the amount of contracted work in the pipeline.
Contingent Liabilities
A contingency represents a current uncertain condition or situation that, when resolved, will result in a financial obligation for the construction company. Typically, these items are not represented in the balance sheet of the construction company until the uncertainty is resolved, at which time recognition would occur in the company’s financial statements. The business owner should maintain a detailed narrative of all potential contingent liabilities, such as legal, employment-related, environmental, income tax uncertainties, and guarantee/warranty obligations.
Unions
If the company’s labor force includes union employees, it’s important to understand new management’s intention going forward. If the new owner contemplates leaving the union, what are the consequences? If the union is underfunded, how will that impact the business? How will an underfunded liability impact valuation?
Captives
Many construction companies invest in captive insurance for reduced premiums and tax benefits, but is it a good strategy for the new owner? It is important to understand the company’s role and performance within the captive to analyze potential exposure going forward.
Minority-, Disability- or Women-Owned Businesses
Will an acquisition impact a company’s minority-, disability- or women-owned business designation? Consult with legal counsel early on when investing in one of these companies to understand the scope of exposure. Buyers should be sure to understand the EBITDA impact of contracts won due to these designations and if similar post-close wins are sustainable.
For more information about due diligence in a transaction involving construction companies, contact your PKF Advisory team member or:
Michael French, CPA, ABV, CFE
Managing Director
Tel: 949.860.9891
Email: mfrench@pkfadvisory.com
