Why Most Construction M&A Deals Fail: Avoid These Common Pitfalls

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ℹ ABOUT THIS EPISODE

Construction M&A deals often fail after closing due to unknown risks and misrepresented warranties. 

Wade Carpenter and Stephen Brown reveal how Representations & Warranties Insurance, Lost Profit Insurance, and proper surety planning protect both buyers and sellers.

Learn why insurance beats traditional escrow arrangements, how to maintain your bonding relationships through transitions, and essential due diligence steps that prevent costly surprises. Perfect for contractors considering buying, selling, or protecting their business value.

⌚️ Key moments in this episode:

• 00:00 Introduction to Construction M&A Challenges
• 00:39 Understanding the Risks in Construction M&A
• 02:11 Mitigating Risks in Construction M&A
• 05:04 Insurance Solutions for M&A Deals
• 09:47 The Role of Surety in M&A
• 17:43 Final Thoughts and Recommendations

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com

Transcript

[00:00:00] 

Wade Carpenter: Nobody wakes up one morning planning to buy another construction company. Maybe a partner wants out or there's a divorce, a competitor's tired, the kids don't want the business, and before you know it, you're signing papers for a deal you never trained for, and inheriting problems you didn't know existed. 

This is the Contractor Success Forum. I'm Wade Carpenter with Carpenter & Company CPAs, alongside Stephen Brown with McDaniel Whitley Bonding and Insurance. And today we're talking about why construction M&A deals don't blow up at closing, it blows up after. And how insurance often is the only thing standing between a smart deal and a big regret. 

Stephen, M&A deals often don't go as planned, so what can we do about it?

Stephen Brown: You're the seller of your construction company and there's a buyer that wants to buy your construction company and there's risk involved. First of all, there's a lot of risk involved with just running a construction company. But there's risk involved financially between [00:01:00] representations of the data that you give a potential buyer.

There may be a broker involved with the sale of a business. There's a lot of due diligence involved. In other words, the buyer is gonna spend a whole lot of time going over minutely, every detail of your business to understand exactly where you stand now financially and what the risks are going forward.

That's today's topic. What are those risks? How do you mitigate those risks? What are a lot of our customers seeing in this merger acquisition process? 

Wade Carpenter: We talked about before the show how construction deals can be an extra risk that you don't have in normal Mergers and Acquisition Deals. You're maybe basing the value on work in progress or your under billings, you could have some problems with warranty exposure.

There's a lot of things that could come up. Disputes with a sub or whatever it is. We had all those employee retention credit deals that some of them could still be under audit, those kind of things.

So there's a lot of things that could be up in the [00:02:00] air. I know I've been on the side of buyers and sellers and digging through the due diligence and there's a lot that's out there.

Construction companies sales, there's a lot of risk you never even think about. So Stephen, tell us a little bit more about what we can do to mitigate some of these risks and why sometimes they would represent that something has a certain value or something like I said, warranty that you don't have some back work that has to be fixed or something like that. 

Stephen Brown: That's a great point. So you've got warranties on your product, you have a timeframe, they have a lot of projects in place that are gonna take multiple years to complete.

What do you do if you're a buyer and you also have all these key employees that are are in the past run this work according to plan? You've got that element in place too, and any of those could cause a huge problem.

What about a subcontractor? A warranty issue regarding a product that you're installing?

So there's a lot of things that are going on when someone's buying a construction company. [00:03:00] Historically you've seen a lot of HVAC contractors, certain trade contractors that had customers that they serviced, regular customers that they serviced.

So there's billable income for that type of work. That's something that any buyer is really comfortable with wrapping their arms around. We do this already. We wanna expand and you're gonna fit in perfectly with our plans.

So you have to think of the reason why someone may want to be buying your company, what your company might be worth to someone else. And if you're a buyer or a seller, you're making all these representations at the time of closing.

I'm a buyer and I like what I see at your company, and a business broker has reached out to you on my behalf and said, hey, I don't know if you're interested in selling your company, but I have someone buying companies now that are giving great EBITDA returns on your assets and then they throw out some rough numbers. Then you're saying, wow, my company doesn't seem to be worth that right now to me. Yeah, let's explore it.

[00:04:00] Usually maybe six month period where buyer and that representative are gonna do their due diligence. And they're really gonna dig into your financials. And they're gonna find everything may not cause that EBITDA to be the number they originally were projecting to get your interest.

But nevertheless, they might find as a seller and you've got your own representative, that your company's worth more than they were originally offering. It's a matter of give and take. 

Wade Carpenter: Yeah, basically you got two sides of it. Your seller is making some promises about the business, that they're telling them the truth about certain things and that kind of stuff. And then the buyer, they're relying on these promises to make sure that they're paying good money for it.

But, sometimes no matter what you do, things are gonna happen. that you've discover something after the deal comes up. And if we don't wanna blow up the deal, but if something happens, what can we do about it? I guess that's part of what we're talking about today. Say they represented that they had a certain amount of backlog and that [00:05:00] job didn't come through, or whatever it is. How can we protect ourselves?

Stephen Brown: That's why the subject is insurance. What insurance and surety bonding products might be in place already to help the sale go through, mitigate the risk on both sides, the buyer and the seller?

A lot of times, a seller will require 10%, say, of the sales price to go into escrow fund, and that's for anywhere from three to seven to 10 years. Who knows? But that escrow is there to take care of any representations or warranties that were made by the seller that turn out to not be accurate. Okay?

Now, there is an insurance coverage policy called Representations and Warranties Insurance. RWI is what it's called. We write it as an insurance agent, a specialty broker who specializes in this type of coverage only. The policy is usually written for roughly what the escrow amount is [00:06:00] or a percentage of the sale.

The premium to buy this insurance policy is anywhere from two and a half to 4%. Usually, there's some markets that specialize in smaller policies and then larger policies for representation warranties. There is no application. The process starts with the underwriter doing the same kind of due diligence on the sale as the two of you are doing when you're selling your company. 

Wade Carpenter: I could imagine an insurance company's gonna dot I's and cross the T's, so it might not be a bad thing to think about. I had never heard of this type of insurance before we started talking about it. I know we've been in some deals where, there's a lot of unknowns and they're chasing, okay, we're going back and forth on little issues, but I could imagine how insurance coverage like this might help maybe have a smaller escrow amount or faster negotiation, things like that. Can you talk about that a little bit?

Stephen Brown: Yeah. Yeah. Or even eliminate escrow requirement. The nice thing [00:07:00] about the RWI policy is it can represent both the buyer and the seller. It represents the warranty. I mean, If you are buying a company, you're not gonna be able to go back after the sale and sue your own employees for any misrepresentations or warranties made in the sale. And I'm not talking about warranties on the products, I'm talking about warranties made as far as the information that was provided to the buyer that didn't turn out for any number of reasons to be accurate.

Nevertheless, the policy's written for usually the amount of the escrow, the premium is roughly two and a half to 4% of that amount. And then the deductible is roughly the same.

So like any insurance, the owner of the policy shares the deductible or the loss retention percentage. But this could be a huge way not have that escrow money sitting for years and years that you could be using.

And also sharing that risk with a large insurance company. Same goes beside RWI [00:08:00] insurance, a product that Travelers has it's called Lost Profit insurance. Basically, we had a podcast on this, but the way that works, you ensure certain losses occurred to your lost profits based on your current operating system and work in progress, your financial information.

The insurance company says, here's what we can ensure against lost profit. What exactly is that insured lost profit due to a storm or a lost Profit due to just simply lost profit. It sounds simple, right? RWI policy, but the underwriting can be very thorough and it takes a while to get through it.

But then again, if you're selling your company or you're buying your company, getting this information together to get a quote for these insurance products, it's not gonna be hard because you're already providing most of the information these underwriters need to know to give you a quote. 

Wade Carpenter: I remember when we did that one. I never heard of lost profit insurance either, and I think there was a lot of interest in that. Glad you brought that [00:09:00] back up. 

The same thing here with a new deal here trying to buy or sell a company, there's a lot of emotions involved and sometimes you start going back and forth in due diligence and I've seen some deals blow up over the smallest things.

I could see how something like this would smooth and make negotiations easier. Maybe, if something does go wrong, less resentment after the sale, and as you said, you can't really sue your employees or whatever. You could sue after the fact and then it becomes a major problem. So this is why this makes a lot of sense to me.

Stephen Brown: It does make sense, Wade. All these moving parts. We've talked so many times about running a construction company is all about managing risk and that's what an insurance company does is manage risk, and a surety company as well.

I'd like to talk too a little bit about the surety aspects of mergers and acquisitions. The number one question is will there still be cash in the company after the sale in order to indemnify [00:10:00] bonding? And if not, who might be available to provide that indemnity or that working capital that you need for surety purposes? In a lot of M&A situations, the buyer just doesn't simply realize how important that surety relationship has been to the continuing growth of that company.

First of all, the capacity to get the bonds they need is more important than the rate that they pay. That could be your lifeblood. What if majority of the work you do is bonded work? So we run into that a lot. A number of our different surety companies have special M&A departments that are trying to help come up with creative ways to get the surety bonding credit taken care of after an M&A takes place.

You can see the point of the surety. They wanna know exactly, okay, the sale's going down. Are we gonna continue to be the surety or are you the buyer gonna move this account to your current surety agent to manage? That's a key question.

[00:11:00] Also, what's there in the current surety relationship that I as a buyer need to know about? The good, the bad, and the ugly. Doing your diligence is to ask those pertinent questions, and we certainly help people with that. A lot of situations there is some sort of short term indemnity that goes into place to keep the working capital present to keep the bonds going. 

Wade Carpenter: I'm glad you brought up the bonding part because that's a big piece that everybody really forgets. And I've seen some deals where people get in there and they take over a company, but they are so strapped and their bonding is hurt by that kind of thing. And they don't think about these things beforehand.

If you got freeze on your bonding or something like that, then bring your insurance agent in on the deal, not springing on them before the before you're about to close. Not to mention the buyer needs to understand that and maybe, hopefully they understand how that relationship fits.

You don't wanna buy a company then have that stripped out from under you. So I think that's a [00:12:00] big part of it.

Stephen Brown: The buyer is buying that team which includes your surety agent, your bonding agent, your accounting, your attorney, your banker, they're buying into the team that you already have in place, or they plan on replacing it. And if they plan on replacing it, how's that gonna affect things going forward. How are you gonna know as a seller things aren't dynamically gonna change for your employees or for you that stay on to finish managing these projects to completion? 

Wade Carpenter: Yeah, I think that's an underrated part of it is the team too. When somebody leaves or whatever, and their CFO is out of the picture or they decide they're not gonna work with the new owners, the bonding, the bankers, it's a big deal. And I've seen it where deals fall apart or companies fall apart because they don't have the same structure, and they don't have the same support.

Glad you brought that part up. But I would guess that not every deal really would need this type of insurance. But can you talk about who this [00:13:00] insurance would be for or should it be for everybody trying to do a deal?

Stephen Brown: I think it would be for anyone where an escrow amount was being required to cover contingency representations of warranties. That's 10%. We see that .

We see the business brokers, the seller, uh, hey, you need to talk to your insurance agent about this and start working on getting a quote for that. The two go hand in hand, the information that's needed by the underwriter and the information that's needed during the due diligence of the buying and selling process is basically the same information.

You're open in communication, there are certain brokers and companies that specialize the larger policies, smaller policy deal would be a, M&A deal that was requiring 10% of a sale or $30 million, like a $3 million policy.

There are some companies that specialize in the smaller policies versus the middle to larger policies, but it all depends on having a good broker. We use a good broker that does [00:14:00] this all the time, immediately can talk to you about the situation and size up what underwriting team of insurance might be best to give a competitive, thorough quote on this. because see a lot of the policy has to do with the exclusions to warranties that you've made as a seller.

Isn't that the purpose of this policy? If you misrepresented key facts in the sale on this policy, then that can be excluded. So answering the right questions is a hundred percent of this type of coverage. What are the right questions? And that just comes from experience.

The lost profit insurance is written a lot through the same surety network that underwrites your potential for the future. You remember I told you that surety bonding underwriters underwrite for the future. So they're always looking at your current cash and your future work in progress. Whether your job profit is tracking if there's profit fades going up or down, how your cash is looking at that particular situation.[00:15:00] 

So you have a company got a good business model and they're selling that's probably the best possible time to get a quote for lost profit insurance. Travelers is telling me they're seeing this project product extremely popular and M&A type deals. It's a certain something extra that you can bring to the table to get more value for your company when you're selling and also to give the buyer more peace of mind. Now, who pays the premium? that's something the two of you could work out or negotiate together to have the right coverage in place.

We talked about the effect on the bond program. We talked about two insurance products, lost profit and representation and warranty insurance, policies for a buyer or seller. There's other considerations you might want to consider.

What if a lot of your work that is being done is a, back order with certain suppliers on key products or components that go into your work? For example, we're seeing a lot of activity in construction of data centers, Wade. [00:16:00] That's a big trend right now. So what if there's key components in your construction project that could make or break you on the job? that's a situation where, the seller could go back and purchase supply bonds on those particular materials and products that would be payable to the company if for some reason that supplier couldn't come through with the product is negotiated.

And we've talked about supply bonds before. They're usually two tenths of a percent of the amount of the supply contract. So the premium is not very much. A supply bond gives you first right on that product. What happens if you have a specked out pump and you're buying the company and all of a sudden, you realize you're having to go through every single purchase order for a job orders that may not have been made on a project that the contract's already been signed? How are you gonna be able to follow all those moving parts so a supply bond is yet another that might protect a company, if that makes sense.

Wade Carpenter: Absolutely. [00:17:00] I think about all the things that could go wrong and things I've seen go wrong on a deal. Some of them went through, some of them didn't. And originally I was asking you like, who doesn't this make sense? And I'm thinking like maybe the smallest mom and pop. But honestly for the price, it sounds to me like it makes a whole lot of sense for anybody to even think about this. If you're selling, you really need to get some I mean, I think it's, cheap insurance as well as, not to mention you have the insurance company backing up the due diligence. They may find stuff, you may not, they may ask some questions, you may not.

Are there other factors of this insurance that we didn't talk about or we should consider or think about?

Stephen Brown: if you'd like to reach out to me, I'd be happy to send you some information. Again, like any insurance products you need to study a little bit. But I think you brought up a key point, Wade. From a seller standpoint and a buyer standpoint, you've got a third party coming in there and looking at [00:18:00] documentation.

Not only are they gonna look at it, but they're gonna take that risk away. As a seller, I don't have to have escrow money put up if I'm gonna buy an RWI policy. So if that premium's two and a half to 4% and they're gonna hold 3 million to a hundred million dollars in escrow, who knows?

It depends on the m and a, sales price. That could free up an awful lot of money for you. Another consideration that we come across all the time is that the buyer is requiring the current owners and management to stay in place for x number of years to see that this progress is gonna progress. So there's a lot involved with tying down that owner to make sure they don't disappear the second you ink the contract exchange of funds for that purchase price. 

Wade Carpenter: As you said, buying a company, there's a lot of moving parts and doing that without protecting yourself is maybe overly optimistic. And everybody wants to think things are gonna always go [00:19:00] right, but they don't always no matter what the intentions are. So with that, any other final closing thoughts on this? I know you'd be glad to talk to anybody about this.

Stephen Brown: Sure, Wade, I would. Reach out to me and I'll be happy to send you some information. This RWI policy, it's not a typical policy that would be covered for one year period. It's covered for the amount of the warranty period. So a lot of these policies could run for six or seven years. That's another good part of this. And my comment to my brokers is you would think after the first year, the exposure to the insurance, carry on this RWI would diminish or go down each year, that you could price it accordingly based on contractual parts of the sale price. But beside that, there's just a lot of moving parts to the policy, what is covered, but it's a great option. It's something to look into. And if you'd like some more information, please reach out to me.

Wade Carpenter: Okay, great. Again, I appreciate [00:20:00] you bringing this to our attention because I never knew it was out there and we see so many of these M&A deals going on right now with construction companies. It's definitely something to consider for both sides, I think. So again, thanks for bringing that to us.

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