Business valuation of home remodeling contractors

Are you preparing a valuation for a home remodeling contractor business? Here are some important industry stats to consider:

The home remodeling companies are usually classified within the specialty contractor industry sector under the SIC code 1799 and NAICS 236220. These businesses generate combined annual revenues of $41.96B. There are some 105,000 such firms in the US alone employing about 474,700 people.

Yet the average home remodeling company is a typical small business – with annual revenues of $400,000 and a staff of just 5.

Business valuation of home remodeling contractor companies

Established home remodeling contractors with a steady pipeline of projects often are profitable, highly desirable businesses. Such companies are sought after in acquisitions and the selling prices offer you an excellent way to estimate your own business value by comparison.

Valuation multiples calculated from these business sales comps are the valuation tools of choice under the market approach. The common valuation multiples used for home remodeling contractor valuations are:

• Business value to revenues (net sales)
• Business value to EBITDA
• Business value to hard assets such as Property, Plant and Equipment (PPE)
• Business value to total business assets
• Business value to owners’ equity

Example: Use of valuation multiples for valuation of home remodeling contractors

To illustrate the market-based valuation technique, let’s pick a typical home remodeling company with the following yearly financials:

• Revenue: $400,000
• EBITDA: $58,000
• Total business assets: $165,500

Now let’s apply a set of reasonable valuation multiples derived from comparable contractor firms that sold recently and calculate the business value for our sample company:

You can use the average value calculated from all the estimates above, or establish your company’s worth as a range of values, from the low to high estimate.

Business valuation for a buy-sell agreement

Quite a few privately owned businesses and professional practices have more than one co-owner partner. Unplanned departure of a partner can have a major effect on the success of a business going forward.

To safeguard business continuity, you as business owners need to plan ahead about how to transfer business ownership interests with minimal business interruption.

In addition, you should think about what the departing partner’s share is worth and the sources of funding for a partner buyout. In such situations, business valuation is a strategic management tool.

What buy-sell agreements do

As business partners you can address the need for such future ownership transfers by creating a formal buy-sell agreement. At a minimum, such an agreement should help you address these concerns:

• Specify which events may trigger the provisions in the buy-sell agreement. Examples are partner departure due to death, illness, divorce, retirement or major falling out.
• Provide a clear way of determining the value of the departing partner’s business ownership interest.
• Specify the sources of funds to pay for the partner buyout.
• Prevent the partner’s share of business from falling into the hands of an undesirable party.
• Word the buy-sell provisions in a way that will be honored by the legal and tax authorities.

How buy-sell agreements are structured

To start, your buy-sell agreement must establish the party that buys the departing owner’s share of business. There are several ways to handle this:

• Entity purchase, where the business buys back the ownership from the outgoing partner.
• Shareholder purchase, where the remaining owners buy the former partner’s interest.
• Wait and see agreement, where the decision as to who buys out the partner is deferred until the triggering event takes place.

Business valuation provision in a buy-sell agreement

How the partner ownership interest is valued is an important part of the agreement. The remaining co-owners must choose how and when the business appraisal is to be done. Your key decision points here are fairness to all the business owners, affordability, and tax considerations.

To be binding, your buy-sell agreement should clearly state the standard and premise of business value as well as the approaches and methods used to calculate the valuation results. The typical ways of structuring a valuation provision for your buy-sell agreement are these:

• A business value figure set by mutual agreement among the business owners. You should update this at least annually.
• A choice of business valuation methods that the co-owners have agreed to use to determine the business value.
• Requirement that a professional business appraiser be retained to conduct business valuation.

Valuation of the entire business is the first step. The next question is how to allocate this business enterprise value among the co-owners.

One option you may choose is to divide the total business value in proportion to the partners’ shares of ownership. Let’s say there are two partners who own an equal share of the business worth $1,000,000. In the pro-rata allocation scenario, each partner owns $500,000 or half of the entire business.

Control premia and minority discounts

If, on the other hand, one partner owns 75% of the business and the other the remaining 25%, the pro-rata allocation may not be the best choice. In this case the partner holding the 75% stake has the so-called controlling ownership interest. This may be more valuable because this co-owner enjoys a number of advantages over the minority partner:

• Decision as to the timing and size of dividend payouts or partner draws.
• Election of directors.
• Key hiring decisions.
• Acquisition and sale of business assets.
• Raising additional capital for business expansion.

The controlling owner’s business share may be worth more than 75% in this case. The difference is referred to as control premium. You can estimate what that premium is by observing the share prices paid by public companies seeking to acquire a controlling stake in other firms.

Once you know the control premium, you can determine the minority discount from it. This will give you the ratio to apply to the pro-rata share of ownership held by the partner with 25% of the business interest.

Business valuation with the Treasury Method – goodwill and assets

If you are valuing an established company, business goodwill may well be a substantial part of the overall business value. One of the central methods to estimate the value of business goodwill is the Capitalized Excess Earnings technique, also known as the Treasury Method.

Business people and financial advisers are sometimes confused by the results they get when estimating the value of business goodwill. Is it possible that goodwill is actually negative? Can business have an unexpectedly high value of business goodwill compared to its industry peers?

A closer look at the Capitalized Excess Earnings valuation method

To address these questions, take a closer look at how the Treasury Method works:

First, the method requires that you specify the current business earnings, usually as some measure of its cash flow. In addition, you need to provide the values of business assets and its current liabilities. Finally, you need to specify the fair rate of return on these business assets as well as the estimate of the earnings growth rate going forward.

The Treasury Method first calculates the so-called capital charge – the portion of the earnings that indicates the return on the business tangible assets. The capital charge is subtracted from your earnings input and what is left is called excess earnings.

It is the capitalized value of the business excess earnings that defines the amount of business goodwill being present.

Some business valuation results may be unexpected

Note that if the business asset base is unusually high, the capital charge may well equal or even exceed the current business earnings. As a result, there are no excess earnings and hence, no business goodwill – at least not in the economic sense.

Conversely, the fair rate of return, representing your business risk, may be high. Here again, the capital charge can quite large even for reasonable values of business assets. The result may well be business goodwill that is lower than you expected.

Ways to handle unusual values of business goodwill

If you run into these situations, here are some ideas to consider:

Carefully examine the values of business assets you include in your calculations. Are all these assets used to produce the business earnings? Uncommitted or overvalued business assets are one reason the Treasury Method may underestimate your business goodwill.

Take a closer look at the fair rate of return on these assets. Ensure that it truly represents the risk associated with the business operations that use the assets to produce the earnings.