Architecture Billings Index - March 2012

Last year I wrote about this indicator and in that posting I provided an overview of what the measurement means relative to the building industry.  If you are not familiar with this index, I encourage you to click on the link at the beginning of this posting for an overview.  I thought it would make sense to provide an update to the numbers and see where we are one year later.

In a nutshell, the index suggests we are about in the same place we were one year ago.  Further, the regional trends are also holding steady.  The national Architecture Billings Index (ABI) came in at 50.4 for March 2012 (compared to 50.5 for March 2011).  Any number north of 50 indicates increased demand for design services (a leading indicator for building).  All regions in the U.S., with the exception of the West, were above 50.0 in March 2012.  The West came in at 46.6, slightly lower than around the same time last year.

So it's been more of the same in the West, a challenging environment that those of us participating in the building economy know all too well.  Hopefully we are bouncing along a bottom and there has been stabilization.  Some good news is that there are bright spots in some of the backlogs we're seeing, opportunities for good work do exist.  At the same time there are those really tough jobs with bad margins still being worked through in 2012.  Last year I stated that it would probably be a few more years before we returned to "times of meaningful growth and strength."  That is still most likely the case.  In the meantime those contractors who remain positive and keep doing what must be done in order to survive and thrive in these times will eventually be rewarded.  We had one contractor say recently he used to work from 7AM to 5PM, now he needs to work from 5AM to 7PM to keep things moving along.  Every contractor needs to commit to work smarter and yes, harder in these challenging times to get to better days which will return.

Do You Have a Concentration Risk in Your Net Worth?

Most small business owners put everything they have into their businesses as they are growing them.  They are entrepreneurs, risk takers and are successful in part because of their willingness to take on risk.  Along the way, they build net worth and value in their business.  They also build a concentration in one stock, the stock of their operating company, comprising a large percentage of their personal net worth.  For most business owners the value in the stock of their operating company, along with the equity in their homes, will represent the vast majority of their net worth.

For most businesses owners, developing this concentration is almost impossible to avoid.  For some it is by design.  Many years ago I was touring a manufacturing operation with the owner who was giving me a tour of his facilities.  I asked him about other investments he had and I referenced the stock market’s activity that day.  We were up on the second floor of his warehouse and he motioned with his arm toward the floor below and said “this is my stock market”.  He went on to tell me he had no other investments and everything was in his business.  Although that works as long as your business works having most, if not all, of your eggs in one basket is generally a dangerous endeavor.  

It’s understood that in order to grow one’s business, capital is required and retaining profit inside the company is essential to its ongoing operations.  The challenge comes later in one’s career, as significant value in the business is accreted, to diversify holdings such that the concentration your business represents in your net worth is mitigated.  There are no hard and fast rules regarding how large this owner operated business concentration should be.  The goal to reduce the portion that your business value represents as a percentage of your overall net worth may not be achievable until your business hits the maturity stage of its life cycle.  That being said, the purpose of this article is to bring the issue to the forefront and have the business owner develop a plan to diversify away from this concentration.  

A goal I have discussed with business owners is aiming for the value of their business to comprise 25% or less of their total net worth.  Any business owner, particularly a construction firm, should seek diversification and mitigate any concentrations in their net worth.  There are a number of ways, after your business has reached maturity, to take some of the chips off the table.  These options include sale of minority stakes to key employees who desire, and are worthy of, equity ownership, sale of non-voting stock (in order to retain control), ESOPs, distributions of excess working capital (yes, this is still possible in 2012 in select cases) just to name a few.  The option you choose will depend on your particular circumstances.  Be sure to include the bond company and bank in any discussion regarding your options.  You don’t ever want to do anything to adversely affect your ability to obtain credit as you do your planning.  As always, consult with your trusted advisors as well.

We’ve all heard that the two of the strongest pillars of wealth are 1) knowing how to make money and 2) knowing how to keep it.  As I’ve cited before, the old saying goes all contractors are one bad job away from going out of business.  The execution of a plan for diversification is essential in keeping a lifetime of work and wealth accumulation intact and provides peace of mind allowing the entrepreneur to sleep easier.

Measure Twice, Cut Once - Maintain Quality in the Estimating Process

Work is hard to come by these days, with all the bidders on jobs and razor thin margins, building quality backlog is not an easy task.  In talking with contractors, I've heard that it requires increased bid activity/volume in this competitive environment to win the work needed to keep the business moving forward.  On the face of it there doesn't seem much to take issue with regarding that statement.  I'm generally in agreement with it as long as the quality and integrity of the estimating process is maintained.

If it takes 100 hours to properly estimate a certain job in the "normal" times, it should take 100 hours to estimate that same job in these more challenging times.  What I've heard from some contractors in recent months is that because they are increasing bid activity with the same or even fewer estimators, the per job bid time is sometimes significantly less.  Some bids that should have taken, say, the 100 hours referenced above are getting bid in as little as 30 or 40 hours.  In order to get the quantity of bids higher, the amount of time per bid has dropped decreasing attention to detailed specifications being called for.  Mistakes are being made.  Whether it is a full line item/trade missed, or parts of the scope of a trade, missing scope of work in your bid will certainly unintentionally improve your chances of winning the job.  The obvious problem becomes how to figure your way out of the hole and mitigate your losses or hopefully make nominal profit.

It is far more important, as with most things in life and business, to maintain quality over quantity.  There's an old saying in the construction business that every contractor is one or two bad jobs away from going out of business.  This is especially true when balance sheets/capital structures have been weakened these past few years by losses.  Be sure to maintain quality in your business processes to ensure mistakes you can ill afford to make are avoided...Measure Twice, Cut Once.

The Importance of Buy-Sell Agreements

As the business owner’s average age continues to increase given the demographics of our population, there are a number of issues that may not have been perceived as important a few years ago that gain increasing attention as time marches on.  The truth is that these issues (e.g. buy sell-agreements, business continuity plans, etc.) have always been important.  There are a number of ways one can exit his/her business.  Many of those exit plans are voluntary and planned while some are not.  These agreements are often times overlooked as there is no sense of immediate need/urgency, etc.  They also generally deal with less than pleasant scenarios that people prefer not to think about.  The reality is that if you want to take care of your spouse and children, you really need to think about how your business is going to produce a liquidity event, in a timely, efficient and fair (think valuation) manner so your family can be well taken care of.  It can also be helpful to you as a shareholder if for some reason you find yourself, or your partner, having to divest from the business for whatever reason.

In basic terms, buy-sell agreements deal with situations whereby a business owner leaves the business through death, incapacitation or some other unexpected set of circumstances.  These agreements are also important in that if your partner is the one who is unexpectedly unable to continue in the business, the buy-sell agreement is the vehicle which will preclude his/her spouse from becoming your business partner.  This last item alone can be very motivational for business owners to address this issue.  

Some of the key terms addressed via a buy-sell agreement include who may buy the business interest, the events that trigger the agreement and the price to be paid for the business interest.  All of these are very important elements and must be addressed thoroughly and with professionals who are expert in preparing such agreements.  There are a few major, critical considerations which also must be addressed when structuring buy-sell agreements; 1) valuation criteria and 2) properly funding the buy-sell agreement.

The valuing of a business, or a share in a business, is an undertaking that can produce varied results.  I’ve said many times over the years you can have one valuation expert arrive at different valuations for different purposes (there are a number of reasons a company may need to obtain a valuation) at the same point in time.  You can also have different valuation firms arrive at very different results all valuing the business for the same purpose at the same time.  The best way to mitigate the potential for an unexpected and/or unfair result is to hire valuation experts familiar with your industry and business.  One size does not fit all when it comes to valuation and the selection of the right valuation firm is critical.  Valuation is contingent on many factors including methodologies, styles and perspectives, who the valuation firm is hired by (buyer or seller), etc.  Within the context of a buy-sell agreement, valuation is further challenging in that the principals are not necessarily looking for a value today, rather the goal is to ascribe a value to a business, or share of a business, at some unknown point in the future. 

The best way to handle the valuation issue in a buy-sell agreement is to have a valuation performed in the first year and then get annual, less expensive updates to that valuation in subsequent years.  Using this process, the many variables associated with properly valuing a business can be addressed given the set of conditions present at that time.  It is impossible to build a formula that will successfully process all of the variables that can change in the future.  That being said, in addition to building in a valuation requirement, it makes sense to insert a formulaic approach into your buy-sell agreement if for some reason a valuation wasn’t performed at the scheduled time(s) as a backup safety valve.  A dynamic formula is better than none at all and can be critical in the absence of a valuation being performed.  Arriving at a fair value for the business is essential to ensuring you and your family’s interests are protected.

Another important consideration in structuring buy-sell agreements is the funding of the liquidation event.  Depending on the particular set of circumstances, there are a variety of ways to fund buy-sell agreements so that the business is not disrupted.  Also, insurance can be an effective tool serving as value preservation in the event that the loss of a key individual adversely affects the valuation of the business.  Generally speaking, there are a number of insurance products used to fund the buy-sell agreements so that the business has the liquidity it needs to pay out the proper value of the business to the appropriate parties.  

A buy-sell agreement that isn’t properly funded is similar in many ways to establishing a living trust without funding it (i.e. converting title of assets into the trust, etc.)  It ends up causing additional heartache and stress and the good intentions of putting such structures in place are nullified by the failure to complete the job and address all the issues up front.  If you do not have a buy-sell agreement in place, or if you are unsure if it’s properly funded, you should reach out to your trusted advisor team and address it immediately.  If your agreement hasn’t been reviewed in a number of years you should revisit it to ensure it will achieve your objectives so you and your family are protected in the event the agreement is triggered.

Changes to Mechanic's Lien and Stop Notice Laws

In September 2010, the Governor signed into law SB 189 which changes certain aspects of the lien law code.  The changes are generally effective July 1, 2012 (unless otherwise noted in the bill).  It is important to familiarize yourself with these changes.  Atkinson, Andelson, Loya, Ruud & Romo did a nice job summarizing the salient points in a two page summary below...

Captive Insurance Programs Under Scrutiny

Many of us have heard of captive insurance plans and have some level of familiarity with them.  In a nutshell, captive insurance plans involve a business forming its own insurance company as a risk management technique.  The basic premise which must be in place is that legitimate risks are being insured and the associated premiums are reasonably priced relative to those risks.  If bogus, aggressive risk pools are created and/or overpriced premiums are being charged, then the captive and all those associated with its formation may be at risk.  I have had conversations with a number of professionals in the business community over the past several months suggesting the IRS and other agencies will be significantly cracking down on abusive plans.

A business contact sent me this concise, one page article last week from the January issue of California Broker magazine.  




The author, Lance Wallach, puts forth some troubling news/information for those who have established a captive insurance plan which may be considered abusive as well as those who helped structure those plans (including the plan architects, insurance brokers, CPAs, etc.)  Mr. Wallach states in the article "...my office has been receiving over 50 calls per month from people that are being threatened with large IRS fines...Not all 412i, captive insurance and Section 79 plans are abusive, listed or reportable transactions, but almost all the Section 79 and captive insurance plans that I have recently seen are abusive...I have had phone calls from taxpayers that contributed less than $100,000 to a listed or reportable transaction and were fined over $500,000."    There is an IRS form, 6707A, which is used "to help detect, deter, and shut down abusive tax shelter activities...The IRS has fined hundreds of taxpayers who did file under 6707A.  They said that they did not fill out the forms properly, or did not file correctly."  Given Mr. Wallach's observations and experiences, if you (or a contractor you work with) are involved with a captive insurance program it may make sense to review the plan with professionals who are expert in this area to ensure you don't get penalized given the recent spotlight focused on captive insurance programs.

For more on this issue and to see Mr. Wallach's credentials, be sure to click on the link above to read the full article.  As always, reach out to your trusted advisors for guidance (or seek outside counsel if these advisors were instrumental in structuring your captive insurance program in order to get an outside opinion).

Workers' Comp Pure Premium Rate To Rise 30% in 2012

On November 4^th, the California Insurance Commissioner approved an increase, effective January 1, 2012, to the pure premium rates for workers’ compensation insurance resulting in an average increase of just over 30% in those rates (to $2.30 per $100 of payroll).  This is the first increase in the advisory pure premium rates since a 5% rate increase was approved by the Commissioner effective January 1, 2009.  In 2010 and 2011, the Commissioner kept the pure premium rates flat despite being presented with recommendations for increases in both years.  Keep in mind workers’ compensation rates are determined by the industry classification code your business falls within.  I was told by a reputable insurance broker contractors can expect to face increases anywhere from 10% to 40% on average.  If your loss history is relatively clean and your business is strong financially, you may see a lesser increase.  Regardless of the code your business falls within, you must begin planning now for these increased charges.  It is also important to note, as I discuss below, that the pure premium rate doesn't necessarily correlate precisely with the premium you pay.  There are a number of variables insurance companies use to affect the premium calculation.

This is very important news for contractors as this will increase the cost of doing business and therefore requires management to revisit the estimating process.  The work you are bidding on now will be bearing this significantly higher cost.  You do not want to be caught bidding work with 2011 rates only to see your backlog in 2012 experience profit fade relating to the higher actual costs of insurance you will be facing.

It is important to keep in mind that although pure premium rates are an input/base in determining workers’ comp rates, they do not account for a number of costs borne by an insurance company.  These costs include administrative/overhead costs and therefore the premium rates that a business pays are generally higher to cover those costs as well.  There may be ways to mitigate the impact of this increase based on your particular circumstances.  I would urge you to contact your insurance broker to discuss as he or she can help by being proactive.  It is also good to include other trusted advisors, such as your CPA and bond agent, in the discussion as well.

Although the increase effective January 1, 2012 will be significant, it bears noting that these rates are still approximately 50% lower than the rates effective July 2003 (when it was an average of $4.80 per $100 of payroll).  That is little solace during these tough times however knowledge is power… Knowing the rates are rising provides you the ability to keep ahead of the curve.