Low Barriers Create High Barriers
Much has been written about the low economic barriers to entry into the construction industry. These barriers have risen somewhat over time; however, it is still a fact that with a little money and a large dose of determination, just about anyone can go into the construction business.
Many of these start-ups fail, yet many more germinate into substantial businesses and create economic vitality for their employees and owners. That is the upside of having low barriers to entry. The downside is the never-ending competition, low margins, and a high overall business failure rate for contractors.
An additional downside is that low barriers to entry can create economic circumstances that impede owners from exiting ownership of their firms.
You may wonder what getting into the business of construction has to do with getting out. To explore this we must first look at why it is so easy to become a contractor. The key factors that establish low barriers to entry in the construction industry are work acquisition through competitive bidding; the relatively low level of capital required relative to revenue generated; and the mobile nature of the construction labor force.
Loyal owners are hard to come by. The reality is that either by public policy or corporate policy, the vast majority of construction work in the United States is awarded using a competitive bidding process. When it comes time to exit a construction business, the dynamic of competitive bidding raises the barriers to achieving a successful sale for the following reasons:
Low Equity-To-Revenue Ratio
One of the hidden “gold nuggets” in the construction world is that it is possible to generate a very good return-on-equity because you can create a large amount of revenue with a small amount of capital.
For example, let’s look at an example of a $100 million volume general contractor that has equity of $5 million and generates 2 percent profit annually. The return-on-equity (ROE) for this contractor is as follows:
$100,000,000 sales x 2% margin = $2,000,000 profit/$5,000,000 equity = 40% ROE
If this contractor decides to purchase another contractor, he is going to want to generate at least a 40 percent return on that investment. Otherwise, he will dilute his margins. To accomplish this, the contractor would be willing to pay only 2.5 times the profit level of the acquisition target. That is not a very appealing multiple if you are the individual looking to sell your business.
Construction Industry Talent
The war for talent in the construction industry is escalating. Simply put, the people are where the real value resides for most contractors. So when it comes time to exit the business, if you do not have a depth of talent, you are not going to find many interested purchasers.
If you try to go out and “buy” talent, you will find it to be a frustrating process. Finally, if you do have some star talent, it is very likely that they will want to buy the business from you. Rarely can they do this outright, however, and you may have to transfer the business to them, essentially by using your own money. If you won’t do this or they don’t like the buyer, they have the option of going and starting their own business.
Lowering The Barriers
How do you overcome these barriers in order to successfully exit your business? Just as start-ups need to be a bit smarter than everyone else, the same logic applies to getting out. Consider the following when formulating a strategic future for your company in order to lower the barriers to exit:
Your company once took advantage of the low barriers to entry to get started in the construction industry. If you are looking to get out, do not forget about these economic conditions when creating your exit plan.
Reprinted with permission from FMI Corp., 919/787-8400. For more information, visit www.fminet.com or call Tom Smith at 919/785-9326.