[Editor’s Note: A mid-June Land & Capital track session at the Pacific Coast Builders Conference in Anaheim set up to be a doozy, titled, “M&A Update: If Not Now, When?” The session’s teaser promised:

 Strong balance sheets and market fundamentals have fueled a flurry of M&A transactions, and the nationwide undersupply of housing suggests the activity won’t be slowing down soon. This panel of M&A insiders will look at the market dynamics for buyers and sellers, giving you a valuable perspective on opportunities, deal structures, and factors that affect your company’s valuation—both qualitative and quantitative.”

 Curating the conversation, Steven Friedman, Director, CohnReznick LLP, delved deep into the dynamic forces, strategies, and motivations that make 2024 both different and the same as other cyclical eras in market-rate housing’s neverending story of big, medium-sized, and smaller homebuilding enterprises. Steven’s two panelists -- Corin Korenaga, a Partner with Cox, Castle & Nicholson LLP, and Luke Klee, a Vice President with Whelan Advisory Capital Markets, LLC – worked with him afterward to assemble an invaluable takeaway analysis from their PCBC session. Steve wants The Builder’s Daily audience to note:

The contents of this article are for informational purposes and general guidance only and do not constitute professional accounting, tax or legal advice. You should not act upon the information contained in this article without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this article.”

What follows is an edited [for style and clarity only] version of Steven’s analysis of his PCBC - Land & Capital session with Korenaga and Klee.]

Here’s a roadmap for considerations and action steps private homebuilding firm owners should consider in evaluating whether to sell the company. If the decision is to sell, we highlight key action steps and decision points to answer before moving forward, and lay out the path a typical sale process will take.

Underscoring the approach we take in this analysis and its details is a caveat we’ve learned from years of experience: What you don’t know can hurt you.

Why is M&A Hot Now?

An owner interested in selling their home building company should be paying close attention to the market. The level of merger and acquisition activity in the industry is the highest it has been in recent memory. Thus far in calendar 2024, there have been more than 10 announced or closed transactions, including:

• Smith Douglas Homes’ initial public offering of equity shares.
• Century Communities’ acquisition of Landmark Homes.
• CastleRock Communities’ purchase of The Jones Company.
• United Homes Group’s acquisition of Creekside Custom Homes.
• Dream Finders Homes’ purchase of Crescent Homes.
• Sekisui House’s acquisition of M.D.C. Holdings (Richmond American), a long-time publicly traded company.
• Landsea Homes’ purchase of Antares Homes.
• Taylor Morrison’s acquisition of Pyatt Builders.
• DRB Group’s purchase of Biscayne Homes.
• Stanley Martin Homes’ acquisition of Prestige Corporate Development.

What’s more, we are aware of many other active discussions among potential home builder sellers and buyers.

Several compelling factors are driving M&A activity:

• The larger public builders generally have very healthy balance sheets with low levels of leverage, making acquisitions an efficient way to grow, both in volume and market share. Given the challenges in organically creating or growing a division, acquiring lots via an acquisition more readily adds to lots owned or controlled.
• Growth by acquisition is a good way for a publicly traded builder to deliver additional revenue and profit, particularly in new markets, and thus enhance its share price, especially if the target company is accretive to the buyer’s business. 
• The fundamentals of the home building business are strong – demand for homes (especially new homes) significantly outstrips supply. Interestingly, home builders active on the buy side are increasing their focus on what historically have been secondary or tertiary markets. 
• Foreign companies, which may face shrinking demographics in their consumer base at home, are seeking to deploy capital in the more favorable U.S. market. 

Builders’ Motivation To Sell

A builder’s decision to sell the company often is an emotional one. Building a successful homebuilding operation takes time, commitment, a willingness to accept financial risk and a strong will. A decision to sell is not easy. Every seller has a personal and unique motivation in selling their business. With that backdrop, our collective experience suggests there are five typical reasons a builder considers selling his or her company:

• Mounting competitive pressure is perhaps the comment we hear most frequently. For private builders without access to the public debt market, leverage is unquestionably more challenging to source. Interest rates are elevated and advance rates generally are down. And the public builders and larger private companies have better economies of scale in construction, access to lower costs of capital to acquire and entitle land and lots, and their local market share often makes them more attractive partners with subcontractors. Larger local market size also gives builders more units over which to spread advertising, marketing, and overhead costs.
• The homebuilding business has never been easy and is – in many respects – becoming much more challenging. Some builders simply say, “I’ve had enough . . . it’s time to sell.”
• Sellers are concerned with managing financial downside. “I’m worried about my personal guarantee on our debt.”
• Some businesses lack a successor. “I don’t have a family generation to follow me;” or “My children have no interest in the business;” or “My team is great at managing construction and finding good land positions, but we don’t have a key strategic leader capable of taking over the company.”
• Timing also can play a part. “Valuations for sellers are high, and I’m financially comfortable. Now is a good time for me to take chips off the table.”

What are Builders' Goals in Selling?

Once a builder crosses the emotional Rubicon and makes a decision to sell, the key next step is to focus on how to get to closing on a successful sale. Note here that the definition of a “successful” sale depends on how the selling builder defines “success.” Anyone else’s view of “success” simply is a poor second place.

Builders looking to sell typically focus on maximizing the sales price and crystalizing the enterprise value they have created over time. In other words, the seller is looking for the highest amount of after-tax proceeds. Given the material difference between ordinary income and capital gains tax rates under existing federal tax law, we have found the highest sales prices don’t necessarily yield the largest amount of after-tax cash proceeds. Tax planning for the sale is an important consideration early in the process. State tax planning considerations (income, franchise, sales and transfer, and recordation taxes) often enhance or impair the after-tax cash proceeds.

Note that we have been talking about “selling the company.” Most homebuilder company sales are structured as asset sales, rather than sales of equity. There are several reasons that asset sales are the preferred transactional structure, but the key driver is the buyer’s reticence to assume the selling company’s enterprise and trailing liabilities.

There is a myriad of other goals in selling that a builder may wish to achieve, including:

• Gaining access to growth capital from a strategic buyer.
• Assuring that the builder’s legacy and reputation are protected.
• Creating growth opportunities for the builder’s executive team and other employees with the buyer.
• Minimizing post-closing liability and reputational exposure.
• Rolling over a portion of their equity into the buying company. However, the potential for a rollover of equity is generally driven by the acquirer and its business model and needs.

Embedded in all these considerations of a seller’s goals lies a further important question:

What are the attributes of a “good buyer?”

In this context, a good buyer can take on different meanings. For example, the good buyer might be the one that has the greatest strategic need to acquire your company and, therefore may be willing to pay more or offer some sweetened nonfinancial considerations. Or the good buyer may be someone who impresses you with their honesty and integrity – a buyer who has a track record of closing on acquisitions with a minimal amount of “noise” or re-trading of key deal points.

In all cases, a good buyer should be one who is willing to take care of the seller’s employees and offer most, if not all, the opportunity to join the buyer’s company.

Initial Steps in a Sales Process 

Valuation

The sales process only makes sense if the firm’s owners believe they can secure a fair price for the company. Sometimes, that “fair price” and the price in the seller’s mind align; sometimes, they don’t. Early in the proposed sales process, it is imperative to determine whether that alignment exists.

Each potential buyer will analyze a target company’s value differently and weigh specific methodologies more than others. The three key valuation approaches commonly used in the market are:

• Price-to-Book Value
• Enterprise Value-to-EBITDA (earnings before interest, taxes, depreciation and amortization), and
• Net Asset Value (fair value of assets less fair value of liabilities).

Additional drivers of value include the expected performance and long-term outlook of the business, strength of the management team, value of future land positions (including the number and quality of lots under control), and financial returns, such as return-on-equity (“ROE”) and return-on-invested-capital (“ROIC”).

Book value consists of the company’s net equity for financial statement purposes, calculated as assets minus liabilities. Home builders historically have been measured as a multiple of book value, but the metric fails to capture the expected future performance of the business. Enterprise-Value-to-EBITDA is used as a means of capturing the value of a company when considering homes in backlog and performance expected from land positions. 

When a buyer plans to acquire only a company's assets, a premium of the “net assets” acquired typically is applied to reach a purchase price. The premium is a function of the company’s backlog, WIP, land positions, and the perceived value of the operating platform.

In the current market environment, there seems to be a growing trend of pricing home builders as the sum of net book value plus a negotiated premium. That premium to net book value can take into account embedded profit in backlog, controlled land (owned or optioned) marked-to-market, or other factors on which the buyer and seller agree. Additionally, premiums are driven by return on equity (“ROE”) or return on invested capital (“ROIC”) that the seller has exhibited and expects in the future.

A builder contemplating a sale is well-served by converting a traditional gross margin analysis to consider ROE and ROIC, if only because the universe of likely buyers will perform that same analysis.

A ‘Circle of Trust’

The thoughtful reader at this juncture will notice we haven’t said anything about lawyers, financial advisors, accountants or investment bankers. And that thoughtful reader is correct.

We cannot overemphasize the importance of confidentiality as the builder considers the sale of their company. And that confidentiality works both internally and externally. A rumor that you may even consider the sale of your company can have negative consequences. For example:

• Customers: “Will they finish my house?” “Will they build it on time?” “Can I get my deposit back?”
• Land sellers/land bankers: “Will they honor their commitments to me?” “Should I find another buyer?” or “Public Company X is interested in that parcel,” etc.
• Subcontractors: “How much do they owe me?” “You know, Public Company Y has been after me to do their work, maybe I should move on. . .”
• Employees: “Should I take that job from Builder A?”
• Lenders: “What do I tell my credit committee about you selling? We just extended that loan for Phase 3. . .”

The owner’s most important ally as they consider selling the company is the chief financial officer, and, if the company is of sufficient size, the controller and the chief operating officer. At the initial stages, the answers to the financial questions will drive much of the owner’s decision-making. The financial team will assemble historical financial data, run pro forma scenarios, and refine the business plan. All of this effort comes on top of the financial team’s “day job” of running the company's financial side. If your company doesn’t have the financial fire power you think it needs, identify and retain a skilled financial professional well-versed in the homebuilding business. 

An additional caveat: Audited financial statements are a necessary first step in any financial transaction. It takes time to get your historical financial results audited, but those audited financials create credibility for your company’s financial track record and will streamline the transaction timeline. Find an auditor that has strong brand recognition and understands the business.

Hiring Investment Bankers and Lawyers

An investment banker is a useful resource to help guide and inform the owners on what to expect during the transaction process, provide a valuation range, and advise on transaction readiness. It’s recommended to seek an investment banker for guidance as part of the decision-making process on whether to proceed with a sale. Once the builder has made an informed decision to sell, an investment banker and a law firm should be retained. The watchwords for the builder remain expertise, experience and confidentiality.

We think the builder must have a good feel for all the professionals – bankers, lawyers and financial advisors. The sales process is time-consuming, intense, and stressful. In most cases, it’s the biggest decision an owner will make in their lifetime. And you want people you can rely on in the trenches with you. And professional fees should certainly be part of the discussion. We cannot overemphasize the importance of experience and personal commitment on the part of your professional team. You’re not hiring the whole firm – you’re hiring the folks on the team to serve your company. Beware the great “bait and switch” – a partner who comes to a pitch meeting but won’t be seen again until closing. 

Steps Before Going to Market

 Data Collection and Access

 In preparation for going to market, the investment banker will spend several weeks conducting its own due diligence process to become familiar with the company's nuances. The information is used to prepare a confidential information presentation, which will contain a wealth of market, financial, and qualitative information. It will also include an investment opportunity or “ask” that the seller is seeking to achieve.

As part of this due diligence and investment positioning process, the builder, the internal finance team, and the lawyers have a lot of work to do, including, for instance, preparing:

• The company’s 3–5-year business plan – starting at the project level and then building to a company-wide financial package. The internal finance team should be well-prepared to explain the business rationale if the business plan shows meaningful backloaded increases in sales and profits. Our experience is that showing “hockey stick” financial projections in the later years invites a high degree of skepticism.
• A “quality of earnings” analysis is a routine step in the due diligence process for private acquisitions. The report assesses how a company accumulates its revenues – such as cash or non-cash, recurring or nonrecurring. Consider doing a sell-side quality of earnings analysis to provide a realistic view of your company’s value, including beneficial “add-backs” to EBIT, to best prepare you for buyer due diligence, and to increase the likelihood of closing a deal. If done well, it should more than pay for itself. Remember that every positive adjustment to EBIT can have a real impact to purchase price once a multiple is applied. 
• Construction-in-process and backlog reports.
• Land and lot option contracts, organized by counterparty, by geography, by year.
• Legal entity and organizational charts.
• Major contracts. Vendors, land sellers, architects, subcontractors, etc.
• Employees and job descriptions.
• Pending litigation and claims.
• Warranty matters.
• Intellectual property.
• Debt maturity schedules, including debt to be repaid/refinanced/assumed at closing.
• Environmental issues.

Putting Investment Bankers to Work

Based on the investment banker’s market and buyer knowledge, they will likely identify a buyer universe that aligns with the seller’s goals. These buyers can include strategic buyers, non-U.S.-based homebuilders and financial sponsors. The considerations in evaluating buyers include:

• Do you plan to sell your ownership interests or your assets?
• What role, if any, do you want post-closing with a buyer? Do you want to sell a majority interest and retain a minority share? Do you want to continue working, albeit as an employee? Consider these questions thoughtfully, but know that much of the eventual outcome depends on the buyer’s wishes.
• Do you plan to sell your ancillary businesses (mortgage origination, title, insurance)? If the buyer has no interest in the ancillary businesses, what is your plan to market them or wind them down?

Managing the Selling Process

 A preliminary step is securing a nondisclosure agreement from all interested buyers and their advisors.

Once an NDA is signed, the buyer and its advisors get access to the electronic data room. That access to information generally will lead to many follow-up questions and requests from potential buyers, often directed to the investment bankers or the seller’s financial team. Attorneys for the buyer, as they focus on legal issues, generally will direct questions to the investment bankers, the seller’s in-house counsel (if there is one), or the lawyers. Our experience shows that managing the volume of requests in the diligence process may make it difficult for a seller to focus sufficiently on managing the core business. Our collective wisdom? Keep your eye on the business – softening results due to a loss of focus on the key aspects of the business too often dilutes a company’s value.

Potential buyers will want to conduct site visits to see your communities and products. You may also want to restrict a buyer’s access to your company’s employees until the closing is imminent.

The key goal in this phase of the sales process is to reach a letter of intent. While not binding, an LOI should have sufficient specificity so that both parties have a good understanding of the key terms and contemplated timing of a proposed sale. Note that even with a signed LOI, there likely will be material open terms and issues that need to be resolved by the time the deal closes. 

One possible wrinkle in the current 2024 cycle is the coming November Presidential election. We think the uncertainty of the Presidential race may drive timelines, so keep the process moving. Give potential buyers a window for preliminary diligence – and stick to it. 

From LOI to Definitive Agreement to Closing

In the current M&A environment, it is not unusual for a proposed transaction to be a so-called “sign and close” deal – meaning the parties sign a definitive purchase agreement and close the transaction concurrently. Under these circumstances, due diligence and negotiating and drafting documents occur simultaneously. For owners accustomed to a multi-step process – signing a purchase agreement, having the buyer approve diligence, and then waiting to close – a sign-and-close structure where either party can walk away at any time can be unnerving. This makes timing even more critical. Issues that can emerge as impediments or otherwise drive timing include:

• Understanding and resolving due diligence findings by the buyer.
• Protracted negotiations regarding hot-button provisions in the purchase agreement. For instance, representations, warranties, and indemnity provisions.
• Drafting disclosure schedules related to the purchase agreement. Experience has taught us that creating these schedules often takes hundreds of hours. Moreover, disclosure is your friend – i.e., a seller is often better served in over-disclosing matters than holding back information.
• Addressing trailing liabilities of the seller. The seller will be interested in ring-fencing post-closing exposure as much as possible, whereas a buyer will want to retain recourse against the seller. There are numerous ways to address these liabilities that experienced deal makers, and counsel will know how to address.
• Home warranty issues. Who is responsible for addressing warranty issues after closing? For how long? At what cost?
• Are there items that require long lead times to address? For instance, obtaining necessary third-party consents and lender payoff letters are common culprits.
• Allocating the purchase price among the assets being acquired. Typically, the seller looks to maximize the amount of sales proceeds treated as long term capital gain; the buyer generally looks to maximize cost of sales expense.
• Negotiating employment agreements for seller’s key personnel.
• Key deadlines. For instance, loan maturity dates, end of fiscal and calendar years, and other events that create volatility in the market (e.g., the November election this year).

This article highlights some of the key issues owners of a homebuilding firm need to consider in evaluating and then executing the sale of the company. The discussion is by no means exhaustive. We’ve tried to identify issues and possible bumps along the road of the sales process. Each transaction has its own nuances, however, we’ve come to believe that the road to closing is more easily negotiated when the seller has a clear vision of goals and objectives and can communicate those goals clearly to a team of competent advisors.