Maintaining Surety Credit in Times of Growth and Transition

Maintaining Surety Credit inTimes of Growth and TransitionMost construction companies in the U.S. are owned by an individual or the members of a family. Yet, according to the Family Business Alliance, only 30% of family-owned businesses survive into the second generation, and just 12% remain viable into the third generation.

That means when owners are ready to retire, they likely will sell to someone outside the family. And with greater frequency, we’re seeing owners sell to private equity firms. From a surety’s perspective, may not be a healthy sign. Most of the time, an acquirer’s aggressive growth philosophy is at odds with the steady, incremental growth we like to see in companies.

Private equity firms seem to be willing to sacrifice bottom-line profitability for top-line revenue since their goal may be to sell the company to another buyer in a few years. Often the balance sheet is not strong enough to support such rapid growth, and this in turn can jeopardize a company’s bondability.

Our advice: Don’t sell to a firm that plans to use debt to achieve fast growth. If your balance sheet gets turned upside down, your surety credit may be reduced or cut off. Your company might not be able to bid on projects that require bonds.

As a seller, you may be thinking, “That’s the new owner’s problem, not mine.” It is your problem, though, if your sale has an earn-out. With reduced bond credit, you may not be able to meet your earn-out goals and have to forfeit part of the proceeds of your sale.

The right way to grow

So what’s the best way to grow, and what are some things to look out for?

We always recommend steady, sustainable growth that won’t put undue stress on your balance sheet. For example, 5–10% growth year over year is probably a good goal, but 30–50% growth might be excessive and stretch your financials.

When considering how much surety credit to extend, we look at two key ratios: working capital (current assets minus current liabilities) and net worth (total assets minus total liabilities). We then apply a multiplier to that number known as the case.

A general contractor (GC) with very little equipment and a small payroll can get by with a 5% case, meaning it may qualify for bonding up to 20 times its working capital and net worth. A road builder with a large payroll and lots of equipment may need a higher ratio, say a 10% or 15% case, since it needs to have more capital on hand if it gets into financial difficulty.

Contractors run into trouble when their work program gets ahead of their balance sheet. For example, if the GC’s case ratio fell to 2.5%, that could be a problem. This can happen when the balance sheet lags behind the contractor’s backlog. A more modest growth level ensures that a contractor’s case ratio remains about where it should be, or that the contractor can catch up relatively quickly.

Worrisome growth

Selling to a private equity firm and buying another company are two of the more worrisome ways a contractor can grow. Both likely will rely on debt to finance the purchase.

As we noted above, a private equity firm’s goal is to maximize growth and pump up the revenue numbers. This may result in an upside-down balance sheet where liabilities exceed assets.

An acquisition poses similar problems. When analyzing the net worth of the new company, surety underwriters don’t count intangible assets like goodwill. Often a company’s name and reputation are worth more to the buyer than their book value, but we can’t count them as assets. It means there are more liabilities than assets on the new company’s balance sheet, and that’s not a good place to be.

A surety will also have concerns about the acquiring company’s ability to manage a business that is now much larger. Suddenly, $20 million in revenue becomes $30 million or $40 million in revenue, but can the new company stay on top of all these projects and effectively track revenue and expenses?

Expansion can be a concern, too                                                        

Concerns about growth aren’t limited to mergers and acquisitions. Contractors can get into trouble by expanding too quickly and becoming overleveraged. Your working capital might get tied up in multiple projects and in expensive assets like heavy equipment, vehicles and tools. Often contractors will reduce their profit margins to underbid a project. Or they may underestimate their costs.

Taking on more jobs and bigger projects that exceed your capacity can lead to overextension, which the Surety & Fidelity Association of America (SFAA) says is the number one reason why construction firms fail. Specifically, SFAA found failures tied to a company’s inexperience with new types of work, expansion into new geographic areas, a significant increase in the size of projects and rapid expansion.

If you’re thinking about expanding your business or selling your company, talk to your surety partner. Your bondability may hold the key to the future value of your company. Maintain your hard-earned surety credit by following sustainable growth practices that protect your company’s balance sheet.

If you have any questions, please contact your nearest local Old Republic Surety branch.

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Erik Mueller

Erik is the bond manager of the Minneapolis, Minnesota, contract branch office (located in Hudson, Wisconsin). He has been in the surety industry since 2007. Before joining Old Republic Surety Company, he was a surety risk advisor at Bearence Management Group and an account executive at Travelers. He has a bachelor's degree in history and social studies from Minnesota State University.