Valuing a Business That Uses Subcontractors

Why do subcontractors change how a business is valued?

They change where the profit comes from and how reliable it is. A business that employs its crews earns its profit from the gap between what it charges and what the crews cost, and it controls those crews. A business that subcontracts earns its profit from the margin on work it wins, prices and manages, and it controls less.

Subcontracting is common across the trades, including electrical, plumbing, building, concreting, painting, roofing, cleaning and security. It can be a sound model. Costs rise and fall with the work, and the business does not carry idle labour. It also brings risks that an employed crew does not, and a valuer has to price them. How trade businesses are valued covers the base method, and this guide covers what changes when much of the work is subcontracted.

How does a valuer assess the margin on subcontracted work?

By testing whether the margin is real, stable and earned by the business rather than by the owner. The questions are these.

• What is the gross margin on subcontracted work compared with work done by the business’s own crews?
• Is the margin consistent from job to job and year to year, or does it depend on a few favourable jobs?
• Are subcontract rates at market levels, or are some set by relationship, above or below what an outsider would charge?
• Who prices the jobs, supervises the work and deals with defects? If the owner does, that work needs a market wage.
• Does the business keep the customer relationship, or does the subcontractor?

The last question matters most. If the business is only an introducer, and the subcontractor does the work and deals with the customer, the margin may not survive a change of ownership. Where the business holds the customer, the contract and the quality control, the margin is more likely to be its own.

A business that subcontracts all of its work raises a further question: what is a buyer actually buying? If the business adds a customer base, pricing, scheduling and quality control, there is something to buy. If it passes jobs along and keeps a small fee, the value may be close to the value of the customer relationships and nothing more.

How much control does the business have over its subcontractors?

A subcontractor is not obliged to take the next job, and can work for a competitor or start a competing business. A valuer asks how much of the work depends on their saying yes.

• Whether subcontractors are on written agreements covering scope, quality, insurance, confidentiality and how the arrangement ends.
• Whether each subcontractor holds the licences and insurances the work needs, and whether the business checks them.
• How many subcontractors do the work, and how dependent the business is on any one of them.
• How long each has worked with the business, and how they are paid and rated.

Concentration here works like customer concentration. If one subcontractor does 40 per cent of the work, the business is as exposed to that person as it would be to a customer providing 40 per cent of its revenue. The figure is only an example, and the closer a single subcontractor gets to doing most of the work, the closer the business is to being that person’s agent.

Quality is part of control too. A customer with defective work will usually look to the business that sold the job and not to the subcontractor who did it, so the standard of the subcontractors’ work is the business’s reputation. How responsibility is shared between the business and a subcontractor is a question for your lawyer.

Will subcontractors stay after the business is sold?

This is the first question a buyer asks, and the answer is often unclear. Many subcontracting relationships are personal: the subcontractor works for the owner and not for the business. A change of ownership is a natural time for them to reconsider their rates or their loyalty.

A valuer cannot know whether they will stay. What a valuer can do is look at the evidence: how long the relationships have lasted, whether the arrangements are written, whether subcontractors have other clients, and whether a handover would introduce the new owner. The risk is reflected in the multiple, or in the earnings where rates are likely to change. It overlaps with owner dependency, because a business that relies on the owner’s relationships with its subcontractors relies on the owner.

What is the classification question, and why does a valuer raise it?

Some workers engaged as subcontractors may work in a way that raises a question about whether they are contractors or employees. That is a legal and tax question. It depends on the facts and the law, and it is for your lawyer and accountant. We do not give a view on it.

We raise it because the answer can affect the costs a buyer takes on, which is why a buyer’s advisers are likely to ask about it. The facts worth putting in front of your advisers include whether the worker also works for others, who sets the hours, who supplies the tools and vehicle, who carries the insurance and the risk of defects, and whether the written agreement matches how the work is actually done.

If your advisers conclude that a different treatment applies, a valuer can reflect their conclusion in the earnings. Until then, a valuer can show how sensitive the value is to the question, which is what the example in the next section does.

How do you compare subcontract and employee costs?

The aim is to put labour cost on a comparable basis, so that the earnings show what a new owner would keep under the model they will actually run. A valuer compares the amount paid to a subcontractor with the cost of employing someone to do the same work. The employee cost includes the on-costs of employment, such as superannuation, leave and workers’ compensation insurance, and any vehicle and tools the business would have to supply. Which on-costs apply to a given business is a question for your accountant. The example below uses illustrative figures.

The same exercise picks up other adjustments that commonly arise where subcontractors are used.

• Payments to family members or related entities, at above or below what an outsider would charge.
• The owner’s own work being paid through a subcontract arrangement, which belongs in the owner’s wage adjustment.
• One-off or peak-season subcontracting that will not repeat.
• Rate changes already agreed that are not yet in the accounts.

What should you gather before a valuation or sale?

A valuer can only adjust for what is documented. For a business that uses subcontractors, useful items are these.

• A schedule of subcontractors for the last three years, showing the type of work, the amount paid each year and how long each has worked with the business.
• Copies of subcontract agreements, and licence and insurance records for each subcontractor.
• How rates are set, and any rate changes in the last 12 months.
• Which jobs are subcontracted entirely and which are done with the business’s own crews.
• Any family or related-party subcontractors, with what they do and what they are paid.
• The owner’s notes on who the key subcontractors are and what would happen if they left.

Our guides on documents needed for a valuation and preparing a trade business for valuation cover the rest. An Independent Business Valuation is $1,995 + GST, and you can begin at our start page. If a sale is the aim, see how to sell a trade business.