Valuing a Construction Company
What is Value?
Fair-market value is the most meaningful standard of value for most
construction company owners. The estate and gift tax regulations define
fair-market value as the price at which the property would change hands
between a willing buyer and a willing seller, neither being under any
compulsion to buy or sell and both having reasonable knowledge of the
relevant facts.
Fair-market value is clearly distinguishable from other standards
of value. For example, investment value is the value of property to
a particular investor based on his or her investment criteria. In contrast
to fair-market value, investment value is the value to a particular
individual, not necessarily value in the marketplace to the hypothetical
purchaser required in the fair-market value definition mentioned. Investment
value can often be affected by elements of synergistic value resulting
from combining similar or compatible entities.
Over the last several years, the construction industry has experienced
many transactions that have occurred at prices which could arguably
represent investment value. The mergers and acquisitions common in the
industry today are occurring at multiples of earnings significantly
greater than the multiples that would traditionally indicate fair-market
value.
Valuation Approaches
There are three generally accepted approaches in valuing any business,
including a construction company: the income, the asset and the market
approaches. The income and asset approaches, however, are the most common
when valuing a closely held construction company.
INCOME APPROACH
The income approach is applied in the valuation of almost all closely
held companies. The income approach focuses on determining the present
value of earnings or cashflow the business is expected to generate in
the future. Two different methods are generally considered when using
the income approach: the discounted cashflow method and the capitalization
of earnings method.
Discounting Cashflow. With the discounted cashflow method,
a normalized level of income from operations is forecasted for a period
of time, usually five years. In preparing forecasts, it is necessary
to consider the capital structure and capacity limitations facing the
company. A common mistake is to forecast revenue growth into the future
without addressing the additional capital requirements the forecasted
level of revenue would require.
The annual forecasted levels of income for the five-year period is
then converted to cashflow and discounted to present value using a discount
rate relative to the degree of risk associated with the income stream,
as determined by the business appraiser. The sum of the present value
of the five-year cashflow and the present value of the residual value
of the cashflow at the end of the five-year period equals the enterprise
value of the company. After company debt has been subtracted, the net
fair-market value of the company is determined before taking into account
any adjustments for lack of marketability and minority interest discounts.
Capitalization of Earnings. With this alternative method,
a single year’s normalized level of recurring, sustainable income
from operations is determined for the company. The value of the company
is determined by dividing the normalized income from operations by a
capitalization rate. The capitalization rate is determined by the business
appraiser after taking into consideration the risks associated with
the operations of the particular company and its earnings stream. Therefore,
if the normalized earnings is $1 million and the capitalization rate
is 20%, the value of the business would be $5 million ($1million/20%
or $1 million * 5). Again, this value is prior to the application of
any marketability and/or minority interest discounts.
ASSET APPROACH
With the asset approach, the business is valued on the basis of fair-market
value of the underlying assets and liabilities of the company. For example,
construction companies that are capital intensive (heavy highway) often
carry equipment at book values well below their fair-market value due
to depreciation deductions. The asset approach would adjust those book
values up to fair-market value.
Specific consideration must also be given to the existence of any
assets and/or liabilities, including intangibles, which may not be reflected
on the balance sheet. Intangible assets common in the construction industry
include name recognition, assembled workforce, bonding capacity, and
contractual relationships and they should be valued by a qualified appraiser.
The company may also possess valuable tools and other miscellaneous
items previously charged to a contract and therefore not reflected on
the balance sheet. This method also requires inquiry into the existence
of any unrecorded or contingent liabilities. Identifying all the liabilities
is very important any time a business valuation is performed, but especially
when done for estate and gift tax purposes.
Allowable Discounts
As mentioned, to determine the net fair-market value of a company, it
is necessary for the business appraiser to consider whether adjustments
for lack of marketability or minority-interest holding are required.
These discounts are appropriate for closely held companies because they
lack the marketability associated with publicly traded stock, which
can be easily and quickly converted to cash. The discount for a minority
interest holding results from the lack of control a minority interest
shareholder has over a closely held company. Numerous studies have shown
that holders of minority interests are not willing to pay the same price
as a shareholder with a controlling interest. According to those studies,
the total combined discount could be as high as 70% in certain circumstances,
with applications generally ranging between 35% to 50%.
Application for Estate and Gift Taxes
When you are ready to pass on all or a portion of your wealth (including
your closely held business interest), the IRS looks to get a piece of
the pie through the levy of various so-called transfer taxes. These
include the gift tax, estate tax and generation skipping tax. The first
2 taxes begin at a 37% rate and increase to 55%, and the generation
skipping tax is taxed at a flat rate of 55%. There are many things that
you can do to cut down on the size of the transfer tax bite. However,
if you limit planning to how you transfer your property at death, you
will miss out on most of the really good techniques which involve transfers
during a lifetime.
There are several reasons for you to make substantial gifts during your
lifetime:
• To avoid gift and estate taxes on the appreciation in value
after the date of transfer
• To avoid state death taxes without paying state gift taxes
since most states have no gift tax provisions
• To receive valuation discounts for gifts of minority interest
in a closely held business
• To take advantage of the annual gift tax exclusion (currently
$10,000 per recipient) which is not available under the estate tax provisions.
A Valuation Discount Model
Let us focus on the valuation discount for gifts of a minority interest
in property. This concept can best be illustrated by an example. Let’s
assume a closely held construction company (ABC, an S corporation) has
a fair market value of $3.25 million. If the owner, Mr. Big retains
100% of ABC until his death, its value for estate tax purposes would
be $3.25 million. If Mr. Big is in a 50% estate tax bracket, the estate
taxes on his business interest will be approximately $1.6 million.
If during his lifetime, Mr. Big transfers 1/3 of his ABC stock to each
of his 2 sons, and retains 1/3 for himself, the fair market value of
the gifts to each of his sons will be less than $1.08 million. This
is because he has transferred a minority interest in ABC to each son.
As discussed above, a minority interest lacks control over business
decisions, cannot force ABC to liquidate, and lacks marketability. As
a result, its fair market value will be discounted. A 40% discount (which
is not unusual) would result in a gift tax value of approximately $650,000
for each gift.
Through gift splitting with Mr. Big’s wife, Mrs. Big, and the
application of each of their applicable unified credits, there would
be no gift taxes due.
Furthermore, at Mr. Big’s death, he would own a minority interest
in ABC and the same 40% discount should apply to the value of his 1/3
interest for estate tax purposes. The combined discount for the 2 lifetime
gifts and the transfer at death totals $1.3 million. In a 50% tax bracket,
that translates into at least a $650,000 savings in gift and estate
taxes. The savings will actually be more if ABC appreciates in value
between the date of gifts and Mr. Big’s death.
What if Mr. Big agrees that ABC will appreciate in value over the next
several years, but is not willing to give up control until he retires?
Assume he is 55 and plans to retire at age 65. Mr. Big can get a minority
interest discount and keep the future appreciation in value of ABC out
of his taxable estate while continuing to control the business until
age 65 by making the gifts of stock to a grantor-retained annuity trust
(GRATs) set up for each of his sons instead of gifting outright to them.
Grantor Retained Annuity Trust
Here is how the GRAT will work. Mr. Big will receive income equal to
a fixed percentage of the initial value of the stock transferred to
each GRAT every year for 10 years (until age 65). At the end of the
10 year period, the stock in the GRATs will be distributed to the sons.
To obtain the value of ABC gifts of stock, the value of Mr. Big’s
retained income interests will be subtracted from the value of the stock
transferred to each trust. For example, if Mr. Big receives 7% of the
initial value of the gifted stock each year and the applicable federal
interest rate is 7.8% (the rate for May 2000), the value of Mr. Big’s
retained income interest will be 45% of the value of the stock transferred
to each trust. If the stock was valued at $650,000 (if discounted as
described in the previous example), the amount of the gift to each GRAT
would be $650,000 less $293,138 or only $356,862.
In this example Mr. Big can remain in control of ABC even after transferring
two-thirds of his stock to the GRATs by naming himself as the trustee
of each trust and having the right to vote the stock until the term
of the trust ends.
Final Caveat
The preceding examples have been oversimplified to illustrate the important
estate and gift tax planning points for consideration by closely held
business owners and their advisers. No one, however, should engage in
any significant gifting program without the benefit of competent tax
counsel, accounting expertise and valuation advice.
James J. Cunningham, CPA, is a Shareholder with Alpern Rosenthal,
one of the largest certified public accounting and business consulting
firms serving Western Pennsylvania. Mr. Cunningham also is a member
of the Construction Services Group of Alpern Rosenthal. He can be
reached at 412.281.2501, ext. 435 or at jcunningham@alpern.com. Heather
J. Baranowski, CPA, MST, CVA, is a Senior Manager in the Business
Valuation/Litigation Support Services Group of Alpern Rosenthal. She
can be reached at 412.281.2501, ext. 396 or at hbaranowski@alpern.com.
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