Contractor Equity Bridge: An Unrecorded Contract Loss and Working Capital Deficiency
Ridgeway Mechanical is an HVAC and plumbing contractor with $46 million in revenue and reported EBITDA of $3.9 million. The two owner-brothers have an unsolicited offer for 100% of the stock and have asked for an independent valuation. Backlog is $31 million, but $9 million of that is a single fixed-price hospital project that is 20% complete; the superintendent's latest cost-to-complete estimate exceeds the original budget by $1.8 million, and the controller has not recorded the loss because the job remains in a cumulative-cost-over-billed position. Other facts: officer compensation of $600,000 versus $320,000 for replacement managers; equipment leased from a brother's partnership at $40,000 per year below market; working capital of $4.1 million versus a normalized level of $5.6 million; interest-bearing debt of $6.5 million, including a $2.0 million SBA loan personally guaranteed by both brothers; cash of $800,000; and maintenance capex of about $700,000 per year against depreciation of $900,000.
1. Compute adjusted EBITDA and determine the correct treatment of the $1.8 million contract loss.
Read the worked answer
Adjustments: officer compensation +$280,000 (excess only); below-market related-party lease +$40,000; adjusted EBITDA = $4,220,000. No adjustment for the aircraft-type items or other discretionary spending appears in the facts.
The contract loss is the trap. Under percentage-of-completion, an increase in the estimated cost to complete a fixed-price contract is recognized immediately and in full, not spread over the remaining term. The controller's "over-billed position" is irrelevant to recognition - over-billing is a balance-sheet presentation issue, not a reason to defer a known loss.
Two acceptable mechanics, one wrong answer. Either (a) reduce normalized EBITDA by $1.8 million if the projection's first year includes the job's revenue and margin, or (b) leave EBITDA at $4.22 million because the projection already reflects the reduced margin on that job, and deduct $1.8 million as a debt-like item in the equity bridge. The error is to do neither, or to do both.
Recommendation: option (b). Treat the loss as a debt-like liability so it is not diluted by a multiple. Also note that because $9M of the backlog is this job, a buyer is effectively buying a known loss, which belongs in the bridge, not in the multiple.
2. Build the enterprise-to-equity bridge and identify which items the offer price is likely to ignore.
Read the worked answer
Assume a 6.0x multiple on $4.22M adjusted EBITDA = $25.3M enterprise value. Bridge:
- Less interest-bearing debt: ($6.5M)
- Plus cash: $0.8M
- Less unrecorded contract loss: ($1.8M)
- Less working capital deficiency ($5.6M normalized − $4.1M actual): ($1.5M)
- Indicated equity value ≈ $16.3M
Points the buyer will press. (1) The $1.5M working capital shortfall is real cash a buyer must inject on day one; the offer that capitalizes EBITDA at 6.0x without this deduction is overstated by roughly 9%. (2) Capex exceeds depreciation by $200,000 per year - a permanent cash drag that no EBITDA multiple captures; a DCF or an EBITDA-less-capex metric should be presented alongside the market approach. (3) The personal guarantees do not reduce value, but they are a deal-term issue: the brothers remain exposed until the lender releases them, and a buyer will use that as price leverage.
Present the bridge explicitly. Two of the four items above are non-operating and neither appears on the balance sheet as presented - which is exactly why the offer price should not be accepted at face value.
3. How much weight should the $31 million backlog receive in the projection, and what checks are required?
Read the worked answer
Backlog covers about 0.67 years of revenue ($31M ÷ $46M). That is a genuine visibility advantage for year one but says almost nothing about years two through five, so it should drive the first projection year only, with later years fading to market growth.
Three required checks. First, verify backlog quality: signed contracts versus letters of intent versus verbal awards, and whether any contract contains cancellation-for-convenience or owner-funded termination provisions. Second, re-underwrite margins job by job - the hospital project proves that budgeted margins are not reliable, so backlog dollars should be converted to gross profit using the superintendent's current cost estimates, not the bid margin. Third, test capacity and bonding: a contractor cannot convert backlog faster than crews, equipment, and surety capacity allow, and growth consumes working capital - which is precisely why the normalized working capital level is $1.5M above actual.
Recommendation: build the projection from backlog-derived gross profit for year one, apply a fade to a sustainable growth rate thereafter, and stress-test a scenario in which the hospital job is terminated at the owner's convenience. Capitalizing backlog directly into a multiple without this work converts a scheduling document into a valuation assumption.