Valuing work in process deals in construction

May 08, 2023

by a searcher from University of Virginia-Darden - Darden School of Business in Bethesda, MD, USA

Hi,

I'm having discussions with a seller in the general construction business on the work that would sell during the LOI period that's before the 'Deal Close'. If he sells it, buys materials for it, and then hasn't completed the work before I buy the business, how is that work valued? How do I compensate him for that? Does he just get all sold work 100% before we close? That also doesn't make sense...

Thanks!

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Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

1) From the brief description, it seems these are short term projects. Hence, POC is not required. Very unlikely seller is using POC.
2) The situation is very similar to a manufacturing company that has RM, WIP and FG ready to ship when order arrives. The difference here is that this is a project-based manufacturing.
3) A conceptual solution, assuming certain accounting practice is followed for inventory valuation, is:
a) Establish WC Target: This should be average WC over a reasonable period, typically 12 months.
b) Make sure backlog has not been depleted prior to close.
4) Reality is, each require a detail analysis of the accounting practice. For example: a) if material is purchased, is it paid? b) if some labor is spent, is it capitalized at month-end, c) has labor been paid or accrued and is buyer assuming that? d) what if labor is unpaid as of the closing date, e0 what if there is cost-over-run? What if customer does not accept the product? What about warranty? etc.
5) Often it is difficult to get above answers. An alternate solution is to pay the seller for the material purchased and paid, plus labor expensed and paid. With this approach, buyer will get 100% of the project profit. Seller may argue on that, and parties may agree to split the profit in some manner.
6) You want to structure the LOI so that seller is motivated to keep building the business, not motivated to accelerate completion, and rewarded for his efforts.

I have been involved with similar transaction many times. Solution is fact specific and often driven by seller and his/her advisor's capability to understand.
Happy to help. DM me.

Reply by a searcher
from University of Pennsylvania in Charlotte, NC, USA

Tough question and good answers above. As others mentioned, the general principle to apply is a transfer of net working capital, as defined, at close and a post-close true-up mechanism. And yes, that's the challenge - how to define the components of net working capital It matters significantly what accounting method has been used - percentage of completion isn't unusual is larger construction companies, but there are other options including what's now GAAP (see ASC topic 606 "Revenue from Contracts with Customers") and variations that may be completely non-standard. As mentioned above the simple solution is pay seller the cost of paid materials in process and cost of labor expensed/paid. Tack on a margin if necessary. But even then be careful - has seller taken deposits, is there retainage involved, etc. - and what's been the accounting for those elements? Of course, the WIP is only one side of the coin - recognition of revenue and cogs is the other - so examination of the accounting is critical.

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