Stephen Crisham is an executive managing director of M&A at Generational Group, a middle market investment bank for privately held businesses. Crisham can be reached at [email protected] or 949.679.4521.
Water has become to this century what oil was to the last: a resource whose limited supply will pose increasingly critical challenges. For that reason, the water and wastewater industry will only grow, and what is currently a fragmented market will undoubtedly consolidate over the next three to five years.
In 2020, for example, our investment firm closed only one deal in the water and wastewater industry. In 2021, there were seven. An enormous number of suitors presented themselves for each of these businesses — in several cases, more than a hundred potential buyers. Truly, when it comes to mergers and acquisitions, water is hot.
Consolidation is Coming
More specifically, there are two main reasons we will expect to see consolidation in the water industry in the coming years: The growing prominence of design-build contracts and a renewed national focus on infrastructure.
Companies and municipal governments that contract for water and wastewater projects are increasingly turning to design-build arrangements, which both lower costs and concentrate responsibility in one firm. The approach streamlines the work and can eliminate a host of delays and confusion. By controlling the process from start to finish, design-build projects can avoid a lot of hiccups along the way.
Thus, contractors that build systems (automated systems, pumps, software, etc.) are buying the environmental-engineering firms that design them. The design side, especially, tends to be made up of small family businesses or those created by, say, engineers who went to school together. It is the perfect environment for consolidation.
On the infrastructure front: Many water systems in the U.S. are antiquated, and some still use lead pipes or brick. California has not built a reservoir in decades, despite a ballooning population, and the state loses more than 80% of its rainwater to the ocean. It is clear we need to find solutions to our water problems, and these problems are only getting bigger.
As the industry consolidates, it is important for water company owners to prepare and understand how these deals work and the necessary steps to become a company that is both ready to sell and is attractive to buyers.
The Parts of a Deal
When discussing the sale of a business, most people discuss the price tag. But that is just one of three components of a transaction, which includes: price, structure and the type of transaction.
The structure involves how long payments will be made, and if these payments will be in stock or cash. This complicates the idea of a simple “price tag.”
The type of transaction has to do with whether it is a stock or an asset deal. In the former, the purchaser buys the shares from the company’s owners, and the company maintains its form, including contracts with employees, suppliers and customers. It also, however, maintains any liabilities the acquired company may have accrued.
With an asset deal, the purchaser buys only the company’s assets (or the ones it wants), such as the name, goodwill, computers, etc. from the company (as opposed to the owners of the company — i.e.stockholders) . It also chooses which liabilities it will take on. That means contracts, including those with customers, must be either assigned or renegotiated.
Sellers tend to prefer stock purchase agreements, which are taxed at the lower capital gains rate (with asset purchases, this is not always the case). Buyers tend to prefer asset sales because they can avoid assuming unknown liabilities.
Indemnifications can influence the structure because the cash at close will be adjusted to accommodate how much money has to be escrowed and for how long. That is a big issue in this industry, especially with wastewater, because a lot of the systems are handled by municipalities, not private companies, and therefore more liability may be involved.
6 Preparations & Considerations for Sale
What other factors are important? Consider the following:
Transaction time
The biggest problem with companies whose exit strategy is a sale is that they simply are not prepared for it. The average transaction takes over a year; just getting the documentation together can take two to three months. And it is critical to get the documentation right. Preparation would be best started two to three years out from a target sale date. And it pays off; skillful preparation will lead to a better price for the seller.
Potential Risks
A primary concern for buyers is risk. Potential risks, in the eyes of the buyer, therefore, affect valuation. As a seller, you want to eliminate as many risks as possible, facts, data and details (remember: documentation) that minimize risks in the potential buyer’s mind.
Leadership
Small companies often revolve around one leader, usually the founder. One aspect of preparation is to make sure the buyer will see that others in the company’s leadership team have relationships with customers and are ready to step into the founder’s shoes. If the buyers will oversee customer relationships, are those relationships easily transferred? If the company is overly reliant on one person, it will negatively affect the valuation.
Recurring Revenue
Another issue in the water and wastewater industry is the higher margin revenue that comes from providing follow-on service. Potential buyers will appreciate recurring revenue from add-on services such as monitoring a water system or automation of traffic controls.
Customer Base
Customer concentration is an important potential risk to consider. Having more than 20% of the company’s revenue come from one customer will not be viewed positively by a potential buyer, because of the risk of that customer leaving after the change in ownership. To the buyer, it can come down to a critical mass issue: the bigger the business, the better.
Quality of Earnings
A quality-of-earnings report has become crucial to selling a business. Once a potential deal gets to the stage of producing a “letter of intent,” in which the parties enunciate their desire to do a deal and summarize the main terms, the potential buyer will hire a third party, usually an accounting firm, to validate the data that underpins financial performance. This includes reconciling tax returns with the reported EBITDA, or earnings before interest, taxes, depreciation and amortization. EBITDA is an essential concept when buying and selling companies, and the valuation is usually based on it. Buyers are thorough and will not miss much. That is why it is important to be ready with extensive documentation to provide the third party for these QOE reports.
In the water and wastewater industry, these reports will have to take percent-of-completion into account for the EBITDA accounting. Do you have open projects that you have not yet billed for? Conversely, have you billed for work that you have not done? In other words, what are the costs in excess of billing and the billing in excess of costs? For a buyer, backlog is a leading indicator of revenue, which is a leading indicator of profit. That backlog will do wonders to boost a valuation.
Stay Ahead of the Trend
The water industry is only going to grow in the coming years, and the growing attention on it will fuel consolidation and an M&A boom. Therefore, it is more important than ever for business owners to understand how selling a business works — and be prepared for it.
