Is now the time to sell your firm?

I remember when the US economy declined and M&A activity slowed in December 2007. It was easy to conclude, after years of robust design and construction activity, that we were no longer in a sellers’ market as the buyers of A/E firms were dictating transaction terms and considerations.  What stood out to me during that time was that the acquiring firms spent more time and due diligence on revenue visibility because a payback on their investment became less certain.  A lot has changed since then.  As we start our annual valuation updates with our A/E clients, I see more firms with increasing confidence in the future outlook for their services, but there is also a talent war that is making it difficult for firms to meet future growth plans.  As a result, ROG is engaging with more firms interested in acquiring A/E firms to fill that talent gap.  Is this the sign for a seller’s market?

Setting aside politics, 2017 began with promise as the Trump administration focused its attention on the US economy by reducing the regulatory environment and promising a corporate tax cut with the latter becoming a reality on December 22, 2017.  Key economic statistics are leading us to believe that 2018 could be another year of growth.  The Architecture Billings Index for January 2018 came in at 54.7, which is the highest level at the start of a year in more than a decade; the Dow Jones Industrial Average increased 24.3% in 2017; the S&P 500 increased 18.4% and; confidence from consumers and small business owners are at highs that we have not seen since the early 2000s.

Timing the market to maximize the value of the sale of your A/E firm can be risky.  The best time to sell is when your near-term growth is strong, and any indication of slowing growth in the long-term is not clearly visible.  We are at a stage in which companies are seeing great growth opportunities, but the access to talent is limited as the good ones are already working.  Does this mean that the cost of acquiring talented employees is about to get too expensive?  Would it be more economical to acquire a firm full of talented employees?  As firms look to fill areas of voids within disciplines, market sectors, or geographic regions it may just be a better opportunity to move quicker by acquiring a firm.

The tax cut is on your side.  The Tax Cut and Jobs Acts lowered corporate tax rates from 35% to 21%, or as I would put it, reduced the tariff of producing goods and services in the US – regardless of where it is consumed.  This means that not only US-based companies would be interested in investing in the US, but also foreign companies because the tariff has been reduced for hiring US-based employees.  The pent-up demand for infrastructure spending, increasing manufacturing investment, and the residential housing shortage are all leading to more upside potential than downside risk in revenue visibility. With valuations being very strong, using your company stock as currency is more attractive because the dilution to your ownership is smaller and the lower tax rate has effectively reduced the cost of using equity securities by 40% (21%/35%).

There are some potential headwinds.  Just as I am writing this article, Jerome Powell, the new chairman of the Federal Reserve, indicated that rate hikes will be needed to keep inflation at a 2% target. Currently, inflation is at 1.8%.  As interest rates climb, your valuation is likely to decrease.  On average, the S&P 500 price to earnings ratio (“P/E”) is around 14 to 16 times.  Today the P/E ratio is 25.7x, which is being driven by growth potential and a low-interest rate environment.  It is not unusual for P/E multiples to fall to single digits when inflation takes hold. With a talent war for qualified design professionals, companies increasing wages and paying out bonuses, the signs of inflationary pressures are a reality.

Even if you’re not ready to sell, taking some chips off the table and taking some of your transaction consideration in stock of the acquiring firm may allow you to enjoy the benefits of today’s higher valuation and still capture the upside potential with your new firm.