How to be a $ uccessful Construction Financial Manager

1. How to be a $uccessfulConstruction Financial Manager Knowledge. Resource. Opportunity.

2. Maximizing the Value of Your Business Presented by:Michael T. Harris II, AFSBThe PrivateBankScott B. Tracy, CPA, CCIFP cliftonlarsonallenllp

3. LEARNING Objectives • Provide a simple, straight forward example of how a construction company is valued • Illustrate how strategic management decisions impact the value of the company • Illustrate the need and the wisdom of including consideration of valuation issues in the on-going management of the company

4. Understanding Value In order to maximize the value of your Company, you first need to know how a Company is valued and what are the key value drivers. Armed with this knowledge, strategies can be put in place to increase the value of the Company in the eyes of the Prospective Buyer.

5. Valuation Approaches

6. Valuation Approaches Three Approaches to Valuation: • Asset Approach - Adjusted Book Value - Liquidated Asset Value • Market Approach - Guideline Company - Comparable Transactions-Private - Comparable Transactions-Public • Income Approach - Single Period Discount - Multi-Period Discount

7. Asset Approach This approach is more appropriate for businesses where the current returns available to shareholders do not adequately reflect the FMV of the business in its entirety. (Pieces worth more than the whole.) In this approach, the assets and liabilities on the balance sheet are adjusted to fair market value and the resulting equity reflects the estimated fair market value of the business. KEY POINT – Methods under the Asset Approach typically imply that there is no “intangible” value to the business or subject interest being valued. Could be appropriate for asset-intensive business or holding companies.

8. Market Approach Methods consist of: • Comparable Transactions - finding actual sales of similar companies and using indicated multiples. • Guideline Public Companies - finding publicly traded comparable companies and using indicated multiples. KEY POINT: Major problem with this method is the difficulty in finding true comparables.

9. Income Approach This approach uses estimates of future cash flows and present value techniques to derive current value. The methods include: Methods consist of: • Capitalized Cash Flow – based on historical performance, adjusted to reflect future expectations. • Discounted Cash Flow – based on a forecast provided by Management.

10. Income Approach Cash Flow X Multiple = Business Value Cash Flow / Rate of Return = Business Value In order to arrive at the business value under the income approach, the valuator must: • determine the appropriate cash flow/net income stream that represents future performance; and • determine the appropriate multiple (required rate of return) to apply to the earnings stream chosen.

11. Income Approach KEY POINT: • The most significant items of consideration in using an Income Approach are: -Income Stream -Discount Rate

12. Income Stream Considerations • Realistic, achievable future forecasts or projections are preferred to perform valuation. -If these exist, a Discounted Cash Flow Method can be employed. • Absent reasonable forecasts, usually the most recent three to five prior years are considered and ongoing earnings are based on recent trends. -If this is the case, a Capitalized Cash Flow Method can be employed.

13. Income Stream Considerations • It is important to choose an earnings stream that is relevant to your Company/Industry. Heavy investments in hard assets; or very high or very low debt levels can dictate which earnings stream is appropriate. - Net Income (includes non-cash items such as depreciation) - EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) - EBIT (Earnings Before Interest and Taxes) - Cash Flow (eliminates non-cash items such as Depreciation) • Whatever earnings stream is used, it must match the discount rate applied to those earnings arrived at from market data.

14. Commonly Used Methods per Industry Sector • Heavy Highway Contractors - Asset Based Approach - Adjusted Book Value • General Contractors - Income Approach - Capitalization of Earnings • Specialty Contractors - Income Approach - Capitalization of Earnings

15. Discount and Capitalization Rates

16. Discount and Capitalization Rates • Once the estimate of ongoing earnings is established, the earnings are converted to a value using a discount or capitalization rate; • These rates are the issue most often contested in business valuation engagements due to subjectivity.

17. Capitalization Rate Example Risk Free Rate 4% (Treasuries) Equity Risk Premium5% (SBBI) Size Premium6% (SBBI) Specific Risk (JUDGMENT)5% (Valuator) Discount Rate (for DCF) 20% LESS Growth Rate(3%) Capitalization Rate 17% Multiple (1/Cap. Rate)5.9

18. Capitalization Rate Example Example • Ongoing Earnings Stream = $100,000 • Times Multiple X 5.9 • Business Value $ 590,000

19. Discount and Capitalization Rates The discount rate is influenced by certain internal and external factors, including: • External -General economic conditions -Yields available on alternative investments -Industry conditions and outlook • Internal -Financial Risk (leverage, liquidity, etc.) -Operating Risk (management, markets, competition, etc.) -Forecast Risk

20. Capitalization Rate –Long-Term Growth Growth – One of the biggest value drivers in a valuation • Can dramatically impact value • Looking at LONG TERM GROWTH - Should it be at least equal to inflation? - Can it be double digit? - What happens if growth is not expected to be constant? - What is the impact on value?

21. Capitalization Rate Example Scenario AScenario B Risk Free Rate 4%4% (Treasuries) Equity Risk Premium5%5% (SBBI) Size Premium6%6% (SBBI) Specific Risk (JUDGMENT)5%5% (Valuator) Discount Rate (for DCF) 20%20% LESS Growth Rate(3%)(8%)(Valuator) Capitalization Rate 17%12% Multiple (1/Cap. Rate)5.98.3

22. Capitalization Rate Example (cont’d) Scenario AScenario B Discount Rate 20% 20% LESS Growth Rate (3%)(8%) (Valuator) Capitalization Rate 17%12% Multiple (1/Cap. Rate) 5.9 8.3 Times Earnings$100,000$100,000 Calculated Value $590,000$830,000 In this case, a difference of 5% in growth resulted in a 40% difference in value!!!

23. Key Value Drivers

24. Key Value Drivers • Earnings – Cash flow is King and will dictate in large part the value -Dressing (your financials) for Success • Management Depth/Succession -Keeping your key people YOUR key people -If you “are the Company”, how do you retain value inside the Company? • Competitive Advantage -What are you known for? Why you and not the Company down the street?

25. Key Value Drivers • Internal Controls -Monthly Reporting Capability -Investment in Construction Specific Accounting Software -Ability to produce 13-week overall and job specific cash flow schedules -Detailed Projections, with base-case, conservative and best-case scenario analysis.

26. Key Value Drivers • Consistent Review and Benchmarking of Key Ratios -Liquidity (Current, Quick, Days of Cash, Working Cap Turnover) -Profitability (ROA, ROE, Times Interest Earned) -Leverage (Revenue to Equity, Asset Turnover, Fixed Asset Turnover, Equity to G&A, Underbillings to Equity) -Efficiency (Backlog to Working Capital, Days A/R & A/P, Operating Cycle) • Consult with Bank and Surety for Peer and Industry Averages

27. Cash Flow is King • Absent a recent history of positive cash flows; value may be limited to the Net Asset Value - Example: NO Goodwill. • You can’t change the past. Prospective earnings are SIGNIFICANTLY more relevant than historical.

28. Cash Flow (cont’D) Net income Plus: Depreciation/Amortization Less: Incremental Working Capital Less: Capital Expenditures Equals: Cash Flow

29. Cash Flows (cont’d) • All other things being equal, a Company that has lower capital expenditure needs into the future (due to prior investments in equipment, etc.) will be worth more than a similar Company that has higher future capital expenditures. -Delaying investments in M&E can harm the Company from a value perspective.

30. Management Depth • Personal Goodwill v. Company Goodwill -Is the value of the Company reliant on a key person/persons? If so, would the loss of those key people significantly erode the value of the Company? -The Company’s Key employees MUST have employment contracts and non-compete clauses or separate agreements to ensure value transfer.

31. Management Depth (Non-compete Agreements) • Non-Compete Agreements Must be legally enforceable (must consult with your attorney to determine rules in your State) -Geographically limited • Is 1,000 miles too much? Is 100 miles? -Limited in time of effect • Will a 10 year time frame be upheld in Court? -Mutual Consideration • Have both parties given up rights and received a benefit to execute the agreement?

32. Competitive Advantage • Management team -Written Succession Plan -Cross trained at key levels -2 people deep in key areas • Strong Capital Position -Strong Working Capital -Favorable debt to equity ratios -Room for additional borrowing

33. Competitive Advantage, Cont. • Geographic Advantage -Key player in Region -Located where Economies are strong and growing -Difficult to penetrate remotely • Specialty Niche -Hospitals; Restaurant Franchises; etc. -Specialization generally allows for higher margins

34. Income Tax Issues • Do you reduce earnings for income taxes (C-Corp or S-Corp)? -In valuing a pass through entity, we will typically impute taxes against the net income, even though the entity itself doesn’t pay taxes. (a “premium” may be added to account for the tax benefits of a pass through entity). -This will lower the value of the company as compared to not tax imputing.

35. Future events considered? • What about that new $50 million contract starting next year? -If you have significant backlog, or know of a pending contract, is this considered? Any valuation that looks only at historical earnings will not consider future contracts. -In most cases, valuators will NOT look beyond the date of the valuation for subsequent events unless they are reasonably foreseeable and can be quantified.

36. Valuation Adjustments

37. Potential Valuation Adjustments • Control – the ability to direct the management and policies of a business enterprise. • Marketability/Liquidity – the ability to quickly convert property to cash at minimal cost.

38. Conclusions • The key valuation drivers are growth (earnings stream) and risk (discount rate) • Positioning the Management team for easier transition is critical to value • A Formal Succession Plan helps ensure that the Company is ready for market at any given moment • A Company can separate itself from its competitors by: -Strong Management -Dominance in Region or Specialty Niche -Strong Financials; strong Growth trends -Having formal corporate documents such as shareholder agreements and non-compete covenants can avoid problems

39. Questions & Contact Information • Questions? • Contact Information Michael T Harris II, AFSB The PrivateBank Managing Director, Construction & Engineering 120 South LaSalle Street Chicago, IL 60603 312.564.3825 (direct) 312.564.6888 (fax) MHarris1@theprivatebank.com Scott B. Tracy, CPA, CCIFP CliftonLarsonAllen, LLP Construction and Real Estate Group 10700 Research Drive, Suite 200 Milwaukee, WI 53226 414.721.7517 (direct) scott.tracy@CLAconnect.com