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New Study Reveals What People REALLY Pay for A/E Firm Stock

If you were interested in buying a house, and the seller told you it was worth $1 million, would you take their word for it and write them a check. I certainly hope not. Ideally, you’d want to see an appraisal. At the very least you’d want to do some research to see what similar homes had actually sold for—what appraisers refer to as “comparable sales.”

Transacting stock in a privately held A/E or environmental consulting firm should be no different. As business appraisers and financial advisers, we make our living helping owners establish the value of their businesses, and transact stock either internally (to other employee-managers) or externally (through a strategic merger or acquisition). But we also realize that not every situation requires a full independent business appraisal. Sometimes all a business owner or a potential investor needs is some independent data on “comparable sales.”

While there are surveys of how firms in the industry value themselves and the formulas they use to do so, there has never been an in-depth study of actual transactions of stock between willing buyers and willing sellers in the A/E industry, UNTIL NOW.

Over the last six months we have been conducting a confidential survey of firms in the architecture, engineering and environmental consulting industry, as well as researching stock transactions in the public realm. The result is the 2014 A/E Business Valuation and M&A Transactions Study.

What makes this study unique is that we have incorporated ONLY data from actual transactions where consideration (cash, notes, earn-outs, etc.) has changed hands between willing buyers and willing sellers. The study examined data from over 200 distinct stock transactions collected via a confidential online survey. We have supplemented this with data collected from publicly available sources. All data was analyzed and compiled by accredited business appraisers with decades of experience valuing privately held A/E firms. The result is the most comprehensive and reliable study on business valuation ever published for the A/E and environmental consulting industries.

Among other information, the study provides statistical data on the following valuation ratios or “multiples.”

  • Enterprise Value / Gross Revenue
  • Enterprise Value / Net Service Revenue
  • Enterprise Value / Pre-bonus EBIT (earnings before interest & taxes)
  • Enterprise Value / Pre-Owners’ Bonus EBIT
  • Enterprise Value / Pre-bonus EBITDA (earnings before interest, taxes, depreciation & amortization)
  • Enterprise Value / Pre-Owners’ Bonus EBITDA
  • Enterprise Value / Number of Employees (full-time equivalent)
  • Equity Value / Pre-Tax, Pre-Bonus Profit
  • Equity Value / Pre-Tax, Pre-Owners’ Bonus Profit
  • Equity Value / Book Value

Unlike any other surveys on the subject, this study examines the differences in valuation multiples between controlling and minority interest transactions, the difference in value between marketable stock (stock of publicly traded firms) and non-marketable stock (stock in privately held firms), and the valuation of stock in ESOP (employee stock ownership plan) transactions. Also provided is a statistical analysis of merger and acquisition deals—including how the transactions were structured, and the forms of consideration paid.

Data from this study begins to quantify concepts like the premium paid for controlling interests in A/E firms. For example, the survey, which includes statistics on 40 controlling interest M&A transactions revealed that earnings multiples in controlling interest transactions were 48% to 80% higher than corresponding earnings multiples in minority interest transactions.

ROGStudy_ControllingInterestimage

As a bonus, the collection of detailed income statement and balance sheet data from survey participants afforded the opportunity to calculate a wide variety of key financial performance metrics—19 in all. These financial metrics are also detailed in the study and include: net service revenue growth rates, various measures of profitability, staff utilization rates, labor multiplier rates, overhead rates, return on assets and return on equity, various balance sheet and leverage ratios, and more.

This study is available for a limited time for only $349. Click here to purchase.

Does the valuation of your company’s stock reflect ALL of its risk?

Whether a business valuation is done for purposes of transferring ownership internally from one employee to another, or for meeting the regulatory requirements of sponsoring an employee stock ownership plan, the risk associated with such an investment is a critical element in determining its value.

So, what is risk?  Oftentimes, an appraiser will look at risk from a business operating point of view.  When valuing a closely held firm operating in the A/E industry, we look for risk in areas such as key personnel, customer concentrations, markets served, and geographic concentrations – just to name a few.  Aside from these, another area of risk to which we’ve been paying much closer attention lately is stock redemption obligation risk. This risk is often accounted for in the discount for lack of marketability.

If your firm receives an annual valuation of its common shares from an accredited business appraiser, then you will be familiar with the discount for lack of marketability.  This is the discount rate that is applied to the underlying security being valued to account for its illiquidity.  In a closely held company, the transfer of shares is often restricted by the terms of a shareholders’ agreement. Often, shareholders in such firms may only sell their stock under certain circumstances and only to certain buyers– typically other employees and/ or the company.  The discount that is applied to account for this illiquidity is determined by many factors, but the most common factors that are considered include; company characteristics such as size, performance, and operating risk; restrictive transfer provisions; dividend payments; rights to sell shares back to the company (“put rights”); information access and reliability; and attractiveness of the industry or company to investors. But because of recent trends in the industry, these factors alone may no longer fully account for illiquidity.

Since the recession, many A/E and environmental consulting firms have postponed their ownership transition plans because their values have fallen, and retiring shareholders have been unwilling to sell at a depressed value. The resulting delay in transitioning ownership has increased the shareholder repurchase obligation risk at many firms because there are more people closer to retirement today than there were in 2008.  Most shareholder agreements stipulate that either the company or its remaining shareholders will repurchase the shares of retiring shareholders. Either way, the company must make available adequate cash flow to fund these obligations.  Competing for this cash flow is the need to reinvest in working capital and fixed assets as the firm grows.  The potential strain on cash flow has the potential to impair the liquidity of the company’s stock, and must be carefully examined by the appraiser and management alike.

Below are the key forces that compete for a firm’s cash flow, and therefore impact its value:

  • Working Capital – most often the biggest working capital requirements of a firm in the A/E industry is accounts receivable.  The slower you collect your A/R, the more cash you’re required to invest in your company.
  • Capital Investment – new equipment, tools, office expansion, and training and development for new employees requires cash.  Will your firm be able to adequately train and equip new employees to deliver the services that your customers demand?
  • Redemption Obligations – on average, 10,000 people a day are reaching retirement age (65) and there is a much smaller group of younger employees available to purchase the shares of retiring employees.  In order to manage their cash flow, many A/E firms will issue promissory notes to ensure that they have adequate cash flow to fund this obligation.  This approach increases financial leverage risk however, and firms should be cautious not to take on too much debt. During the recession, the biggest factor that distinguished surviving firms from failed firms was their ability to service their debt obligation with lower revenue and earnings.
  • Incentive Compensation – for many firms, incentive compensation has not returned to its former levels.  In fact, there are still many firms that have yet to reinstate their 401(k) matching programs.  Will your firm have adequate cash flow to keep your talented employees?  If too much annual cash flow is required to service the debt obligation of repurchased shares at the expense of incentive compensation, you could have difficultly retaining your key employees.
  • Return on Investment – a key factor to creating demand for ownership in a closely held company is the annual profit distribution to shareholders.  Typically, shareholders are paid “last” (i.e. after employees, vendors, debt holders, etc), but have the highest reward potential.  If your firm is unable to make meaningful profit distributions to shareholders, this could have a significant impact on share liquidity as many buyers depend on the return to help fund the cost of their investment.

Over the past two years, we have seen more firms shift their cash flow allocation to improving shareholder liquidity, but this has come at the expense of allocating cash flow to incentive compensation.  The valuation of your company must consider not only  the liquidity risk of the shares, but the risk of not being able to invest in growth because of increasing cash flow demand for shareholder repurchase obligations.  Reviewing your shareholder and employee demographics should be considered when understanding the risk of owning stock in your company.

maysemboilerIf you are interested in learning more,  we will be conducting a one-day seminar on ownership transition strategies at the San Diego Bayfront Hilton on Thursday, May 15th.  Come join Steve Gido and me as we present options that address your ownership transition challenges while managing your valuation risk.