Using Due Diligence to Verify Assumptions and to Identify Risks in Acquisitions of General Contracting Companies

by Arif S. Haq

In recent years, certain niche markets in the commercial construction industry have experienced considerable consolidation. While consolidation can provide economies of scale and other advantages, potential buyers should be wary of numerous pitfalls involved in acquisition transactions in the commercial construction industry. This article will identify some of these pitfalls and examine how a buyer can avoid acquisition transactions that are likely to turn from opportunity to disaster. Generally, this process is referred to as "due diligence." Its primary functions are to verify the assumptions underlying the attributed value of the target and to identify material unknown risks involved in the transaction. Although this article describes due diligence concepts in the context of an acquisition, these concepts should be applied in any transaction where one construction company will be acquiring an interest in the construction business of another, whether it be an acquisition of stock or assets, a merger or a joint venture.

Verifying Valuation
Assumptions

Every acquisition transaction is based on an initial valuation of the target company, and every business valuation is based on numerous assumptions. Once the initial terms of the deal, including the purchase price, have been determined, the buyer should turn its focus on verifying the assumptions that underlie the initial valuation. Otherwise, the buyer may find out after closing that it paid too much for the target's business.

An initial business valuation is usually based on a combination of factors including the value of the physical assets being acquired and, in some cases, an estimate of the target's future revenue. The value attributed
to the physical assets being acquired is usually based on an assumption that such assets are suitable for their intended use and are in good working order. As part of its due diligence investigation, the buyer should verify this assumption by conducting a physical inspection of the physical assets being acquired. A further assumption made regarding physical assets is that they are not encumbered by any third-party liens. The buyer should verify this assumption by performing searches of the appropriate public records for liens filed against the target. Of course, the target should still warrant to the buyer that the physical assets being acquired are suitable for their intended use, in good working order, and free and clear of
all liens and encumbrances.

If the initial valuation of the target was based on revenue (whether in whole or in part), the assumptions underlying the target's revenue estimate will need to be verified. In the construction industry, revenue estimates are a function of the projects in the target's pipeline (pending bids (including negotiated bids) that are likely to be accepted, accepted project bids and projects under contract). Once the due diligence process begins, the buyer should begin the process of verifying the existence of projects that it has been told are in the pipeline. The buyer can verify projects under contract by obtaining a copy of the executed general contract and, if the project has begun, by visiting the job site. Accepted bids can be verified by obtaining a copy of the award letter, notice of intent or similar document from the owner/developer. Since pending bids are not "contracts in the door" and may be difficult to verify, the estimated revenue of each pending bid in the target's pipeline should be discounted significantly or ignored, depending on the circumstances, in establishing the value of the target's business.

In addition to confirming accepted bids and projects under contract, the buyer should undertake to evaluate the likelihood that each project in
the target's pipeline will be profitable. It is important to remember that, at the time of the initial valuation, the buyer likely did not have access to the estimates, budgets, forecasts and job cost histories prepared by the target for the purpose of pricing each project, thus the buyer could only assume that each of the projects in the pipeline will be profitable. If this assumption turns out to be false, the buyer will overpay for a business which may eventually lose money, thus turning an opportunity into disaster.

To determine whether each project in the pipeline is likely to be profitable, the buyer should review the target's estimates, budgets, forecasts, job cost histories and other accounting records for such project. The buyer's project managers should verify whether the target's budgets and accounting records reasonably estimate the cost of such project and whether the buyer can achieve an acceptable profit margin on such project. Verifying project profitability in this manner can be a difficult and time-consuming exercise, but it is well worth the effort to know you are not spending money to lose money.

An issue related to the profitability of the target's projects is the revenue/cost split that the buyer and the target will have to agree to at closing with respect to each on-going project. The buyer should be wary of the target's accounting practices in relation to determining how much of an on-going project has actually been completed. In particular, the buyer should make sure that any disproportionately large costs that will be incurred by buyer toward the end of a project are properly considered in determining the revenue split for that project.

Identifying Unknown Risks

In addition to verifying assumptions underlying the initial valuation,
a thorough due diligence investigation can also reveal whether the proposed transaction involves any material unknown risks. Every acquisition or merger involves numerous risks. Some risks, such as subcontractor and purchase order
buy outs, general market risk, labor efficiency risk, employee attrition and currency exchange risk, are generally known to the buyer taken into account in establishing the initial purchase price. Other risks relating to the transaction, however, are not known
to the buyer and must be discovered prior to closing through an investigation of the target's business.

Transferability of Contracts

A general contractor's most critical asset is its general contracts with owner/developers and its subcontracts. Thus, every acquisition of a construction business involves the risk that the target's contracts cannot be easily transferred to the buyer. If the transaction is structured as an asset purchase, the target will have to assign all of its contracts to the buyer. In many cases, these contracts will require that the target obtain the consent of the other party to the contract before assigning the contract to the buyer. Depending on the circumstances, the other party may not be willing to give its consent to such assignment. Thus, for each contract, the buyer must determine whether the assignment of such contract requires the consent of the other party and whether the other party is willing to give such consent. In some cases, the other party may insist that it receive some accommodation
in exchange giving such consent. For example, if there are existing disputes between the target and the other party, it is very likely that the other party will insist on a favorable settlement of such disputes as a condition to giving its consent. Further, owner/developers may require assurances that their project will remain under the management of the current project management team.

Form of Contracts

In addition to possible nontransferability, the target's contracts may present additional risks that were not known when the original deal was made. Thus, as a general matter the buyer should have its counsel review each contract that will be assumed by the buyer to determine if the allocation of risk differs significantly from the allocation of risk established by the buyer's normal contracting practices. This can be particularly important in relation to delay clauses in general contracts, since such clauses can often mean the difference between a profitable project and an unprofitable project.

The form of the target's subcontracts will also present some important issues for the buyer's consideration. For example, if the target's subcontracts do not contain an enforceable "pay if paid" clause, the buyer may have to pay the target's subcontractors before payment is received from the owner/developer. It is important for the buyer to remember that, even if a subcontract contains the appropriate provision, not all states will enforce a "pay when paid" clause against a subcontractor. In any event, to the extent the target's subcontracts do not contain enforceable "pay if paid" clauses, the buyer should be aware that increased capital reserves may be required to pay the target's subcontractors prior to receipt of payment from the owner/developer.

Non-Payment of Sub-contractors and Suppliers

Another potential risk involved in the acquisition of a general contracting business is the risk that the target may not be paying its subcontractors or suppliers in a timely manner or that such subcontractors and suppliers have claims against the target's projects. To manage this risk, the buyer should review the target's purchasing and payment records for all on-going projects to verify that the target has paid its subcontractors and suppliers on time and in full and has obtained appropriate waivers and lien releases from each of them. The buyer may also search the public records where a subcontractor would file claims of liens and preliminary notices of lien rights with respect to each on-going project and each project completed within the last year. Even if the buyer takes these measures to confirm the timely payment of subcontractors, the target should be required to indemnify the buyer for any failure to pay subcontractors prior to closing and to establish an escrow fund to secure such indemnity.

Surety Bonds

Another significant risk in any acquisition of a construction business is the risk that the method of transferring the target's contracts will release the sureties of the target's subcontractors from their respective bond obligations. Such a release may expose the buyer to the risk that no surety
will be available to make the buyer whole in the event a subcontractor fails to perform. To manage this risk, the buyer should review each bond to determine the effect of the acquisition on the surety's obligations. Unless it is clear that the surety will not be released as a result of the acquisition, the buyer should obtain a reaffirmation of the bond by the surety in connection with the closing.

In addition, the surety bonds of the target will need to be reaffirmed by the target's sureties. Otherwise, a default could result under the target's general contracts. Obtaining such reaffirmation may involve the buyer and/or its principals providing substitute indemnities to the applicable surety. If so, the bonding capacity of the buyer may become an issue in the acquisition.

Licensure

Many states require that general contractors have a state license in order to undertake construction projects in their state. Similar to the transfer of general contracts, the transfer of licenses can be a significant concern in an acquisition transaction. Often, a particular license is held in the name of an officer or employee of the target who will not be joining the buyer's organization following the acquisition. In other cases, the transfer of a license issued in the name of the target may take a significant period of time to complete. In either case, the buyer could find that it would be undertaking projects in states where it is not properly licensed. Further, the failure to have a license may be a default under the applicable general contracts and the related performance bonds. Thus, the buyer must ensure that immediately following the closing it will have all state licenses necessary to perform the projects it will be undertaking.

Sufficiency of Assets and Personnel

Another key concern in any acquisition of a general contracting business is whether the operating assets and personnel being acquired will be sufficient to perform the target's contracts. If such assets and personnel are not sufficient to perform all of the target's obligations, then the buyer will incur additional costs, which could be substantial, to perform such obligations. To determine whether the target's assets and personnel are sufficient to perform its obligations, the buyer can obtain client satisfaction surveys from owner/developers of completed projects. The buyer can also contact the target's surety to determine whether the target has had an abnormal history of claims against its payment and performance bonds and whether the target's bonding capacity is declining. Finally, the buyer can review the target's litigation records to determine whether the target has been involved in an unusually high number of lawsuits relating to its construction projects. Each of these methods will provide insight regarding the target's past performance and will indicate the quality of its personnel and operating assets.

With respect to project management personnel, the buyer should further investigate whether such personnel are diligent in preserving the target's rights under its contracts with owner/developers and subcontractors. To accomplish this, the buyer should review the target's correspondence files for each project to determine whether the target's project managers comply with applicable notice provisions of each contract. Further, the buyer should investigate the reputation of the target and each of its project managers, both with subcontractors and with owner/developers. In some cases, a general contractor who is known to be efficient and trustworthy can obtain better prices and thus obtain a competitive advantage over others in the marketplace.

Worker Safety

Yet another risk that can significantly impact acquisitions in the construction industry is poor job site safety. If the target's job sites are unsafe, the buyer may eventually suffer an increase in workers' compensation premiums and a decrease in employee morale. Moreover, if conditions at the target's job sites violate standards promulgated under the Occupational Safety and Health Act of 1970, as amended, the buyer may incur significant penalties for such violations. To investigate and manage this risk, the buyer should not only visit several of the target's current job sites and interview the target's foremen and workers, it should also obtain a claims history from the target's workers' compensation carrier. The buyer should also review all correspondence between the target and governmental authorities that regulate working conditions, such as the U.S. Occupational Safety and Health Administration, and obtain a record of any penalties previously assessed against the target by such authorities.

Conclusion

The foregoing is by no means an exhaustive list of issues that should be investigated by a buyer acquiring a general contracting business. Every transaction and every target is unique. Thus, the buyer's acquisition team must be able to adapt the due diligence process to the target and the structure of transaction in order to achieve the primary purposes of due diligence-the verification of valuation assumptions and the identification of unknowns risks.

Arif S. Haq is an attorney in the corporate/mergers & acquisitions practice group of Smith, Gambrell & Russell, LLP (Atlanta, Georgia)