A well-crafted shareholders agreement is the foundation of any professional service firm’s ownership transition plan. In privately held firms (which make up the vast majority of firms in the A/E industry) this is the document that governs how ownership is transacted by and between the company and its shareholders. A good agreement will speak to virtually any circumstance that may arise, and specify the obligations of the company and shareholders in each circumstance with respect to ownership.
With over 20 years of ownership planning consulting work we’ve seen great examples of shareholders agreements, and some poor ones. The best examples have been thoughtfully crafted by an experienced attorney from the start, and regularly revisited and amended to remain relevant in the ever-changing tax and legal environment.
Based on that experience, below are some core elements that all agreements should include, or at least consider.
Events triggering stock redemption: One of the primary goals of a shareholders agreement in a professional service firm is to ensure that the company’s stock remains in the hands of employees. Therefore a good shareholder’s agreement will mandate the redemption of stock from a shareholder (or his or her estate) in the case of death, disability, marital dissolution, bankruptcy, termination of employment and other events that might otherwise cause shares to fall outside of the control of the company and its active employees. It might also cover events such as a shareholder’s loss of professional license, or other events that might limit the contributions of a shareholder to the company.
Stock valuation: A privately held firm must have some method of establishing its value for transactional purposes. This method should be clearly defined in the shareholders agreement. Some firms will simply mandate that a valuation analysis be conducted annually or as needed by an independent professional appraiser. Other firms employ a stock valuation formula, which is carefully defined in the agreement, often with a sample illustrating the application of the formula.
For companies that have a policy of carrying life insurance on key employees, the stock valuation language should be very specific as to how the cash proceeds from such policies will be accounted for in the valuation, and how the proceeds will be applied in the repurchase of the deceased shareholder’s stock.
Financing provisions: In order to protect the cash flow and solvency of the company, a good shareholders agreement will contain provisions that allow stock redemptions to be financed with notes payable to the selling shareholders. Financing terms are often as long as eight years, with the company having the discretion to decide whether or not to use financing, and if so, how long the term should be.
Non-solicitation and/or non-compete covenants: Non-compete agreements can be controversial, and their enforceability depends greatly on how restrictive they are and the governing jurisdiction. That said, the departure of a major shareholder (pre-retirement) has the potential to be very damaging to the company and its remaining shareholders, particularly when the company has a major financial obligation to the separated shareholder. It is therefore reasonable to include language in your shareholders agreement that restricts a separated shareholder from actively soliciting clients and employees.
Tag-along / drag-along rights: The rights of minority interest shareholders in a merger or acquisition scenario is an important one to address in your shareholders agreement. In the event that a majority of the shareholders decide to sell or merge the company with an outside entity, tag-along / drag-along rights give minority shareholders the right to require that their shares be treated in the same way as those of the controlling interest shareholders (i.e. they may “tag-along”). Conversely, this provision allows controlling interest shareholders to require the minority interest shareholders to participate in the transaction (i.e. they may be “dragged along”).
Mandatory redemption provisions: This is another sensitive topic, but a trending one. More and more companies are choosing to include language in their agreements requiring shareholders to begin to divest of their shares as they near retirement. Such provisions should not be confused with mandatory retirements. The goal of the provision is to allow companies to project and plan for future stock redemption liabilities by removing the uncertainty surrounding when a shareholder may choose to retire. As an example, an agreement might mandate that a shareholder begin divesting of their stock at the rate of 1/5th each year beginning at age 60, causing the shareholder to be fully divested by age 65.
Once again, the above topics are not meant to be a comprehensive list of every provision to include in your shareholders agreement, but they should provide some food for thought. If you’ve not reviewed your own shareholders agreement in some time, you might be overdue or a tune-up.
Most larger firms – 80 staff members or more – have a CFO on staff and enjoy the benefits of their executive presence, technical knowledge and business acumen. But what about smaller firms? While a great CFO is worth their weight in gold, small firms typically cannot afford the $150,000+ salary, even though they would profit tremendously by having that skill set on their team. The solution: the fractional CFO.
What Does a CFO Do, Exactly?
Ask a CFO what they do, and you are likely in for a long conversation. In a nutshell, the CFO oversees the financial health of the company. Within this framework, there is a myriad of tasks and responsibilities, especially in a small firm where they might have a hand in areas like IT, HR and project operations, to name a few. Besides the traditional activity of producing accurate and timely financial information, a CFO will:
How Can Your Firm Benefit from a Fractional CFO?
If you already have a full-time CFO on staff, consider yourself fortunate. For firms that can’t afford, or just don’t have the need to hire someone full-time, hiring a fractional CFO is a flexible, cost-effective solution. A fractional CFO is a part-time contractor you hire to provide CFO services when and to the degree that you need them. You are essentially paying them an hourly fee on an as-needed basis for a scope of services that you mutually agree upon. The scope might be a block of time per week or month, a specific project, or duration of time. This is a great way to get the expertise you need and control the cost of that service. And the peace of mind in knowing that the financial health of your firm is in expert hands will help you sleep better at night!
How to Get Started
Here are a few suggestions to get you started on utilizing the services of a fractional CFO.
Having a CFO on your team is an integral component to the profitability, longevity and stability of your firm. The question is not whether you can afford one but whether you can afford not to have one on your team. If you would like to know more about how a fractional CFO can benefit your organization and how we can help you, please give us a call.
How has B&L’s performance fared so far in 2018?
Performance for 2018 has been strong to date. With this trend, we are optimistic we will meet or exceed our 2018 goals for revenue and staffing. We are definitely seeing workload pick up in all markets as our backlog is up more than 21% year-to-date. Many opportunities are available, but competition remains high. We continue to service our core clientele while making smart go/no-go decisions to make the best use of our resources in expanding markets.
Given tight labor markets for A/E professionals, have you had to change your approach to hiring and retaining talent?
Like most firms, we definitely have become more aggressive in both the recruiting and retention of talent. For recruiting, we continue to advance our efforts on many different fronts including, increased internal recruiting incentives, retaining a search firm, launching a new website, and pursuit of a dedicated talent acquisition position. Retention efforts have come from promoting our family culture and core values, accommodating flexible work schedules when possible, enhanced training programs, and ensuring our benefit packages are competitive.
You became B&L’s President and CEO in 2017. Have there been new policies or initiatives you’ve chosen to pursue?
In my short time as President and CEO, the focus has been on reinvesting in our most valuable asset, our employees. In 2017, we made significant improvements to our benefits package to make it more competitive in today’s market. These improvements include providing a more robust retirement savings to our employees, converting to a PTO policy, and adding a holiday. We also invested in our fleet vehicles, which has helped with efficiencies, and overall program savings. As we grow, we continue to look at options for the overall company structure to improve on our already high client satisfaction and allow for efficient integration of acquisitions.
You recently launched a brand new website look and layout. What were your goals in how you present the company online?
Since it was more than 10 years since our last website update, it was definitely time for a website overhaul. The main goal was to provide a clean looking responsive website design that incorporates new technology and videos to highlight B&L’s family culture, core values and technical expertise. The new site allows a simpler user experience and helps recruit top talent to the company.
B&L has made select niche acquisitions of design firms as means of growth. What do you typically look for in target firms?
Once you analyze the initial key indicators of size, financials and market areas, it really comes down to focusing on personnel, synergies, and culture. At the end of the day, both firms need to come out stronger with the merger, leading to synergistic long term growth and stability. If the overall culture and core values do not align, then the chances for long term success are diminished. Supporting talent and resources are also considered, including how they can adapt into the team over the long term.
What are your plans this summer for rest and relaxation?
For me, rest and relaxation comes from spending time with my family. My family loves to hike and we typically plan various mountain excursions throughout the summer. Venturing into the backwoods and enjoying God’s creation has always has been relaxing for me, and it’s a great way for my family to unplug from today’s world and spend quality time with each other without all the technology and distractions. It’s good exercise too!
How has DEA’s performance fared so far in 2018?
Our fiscal year starts in November, so we recently finished the first half of 2018. We are seeing very robust, organic growth and our overall performance is better than last year.
Given tight labor markets for A/E professionals, have you had to change your approach to hiring and retaining talent?
Our first priority is to retain our talent. We give close attention to retention factors such as employee appreciation/recognition and sharing news of the firm’s performance and projections. As we grow, there are new opportunities for our people to develop their careers and make a difference. On the hiring side, we recently implemented an employee referral program to encourage employees to recruit for us. Hiring has been challenging, but our in-house recruiting team has done a fantastic job of finding talent.
DEA works in various markets from transportation to energy to land development across offices nationally. Where have you seen the most promising opportunities for growth?
Geographically, all of the markets in the western U.S. are hot. For DEA, the greatest opportunities are in the transportation market.
DEA has acquired several engineering firms over the last 5 years as a means of strategic growth. What do you typically look for in target firms?
The number one factor for us is cultural fit. We believe that cultural fit is essential to subsequent integration and a merger’s success. We begin by assessing whether the outlook of a firm’s top leadership aligns with our values and core ideology. After that, we look for a strategic fit and how a firm fits into our overall strategy.
You have been with DEA since 1988. What advice would you give young engineering professionals starting their careers today?
Think about how you can make a positive difference from day one. When you do something that you are passionate about, it will help you enjoy life.
What’s on your summer reading list?
I am reading Playing to Win, How Strategy Really Worksby A.G. Lafley and Roger L. Martin in preparation for our company’s strategic planning session.
How has ISG’s performance fared so far in 2018?
To date, 2018 is shaping up to be a fantastic year for ISG. We are up approximately 27% in revenue from 2017 year on year to date. In general, the markets we serve are trending positively. Being busy, I think we lost a little focus and tried to stretch a little on some proposal work early in the year. We could have fared better in that timeframe, but a market leader retreat helped right that before any pain was felt, and we are back on a nice winning streak.
Given tight labor markets for A/E professionals, have you had to change your approach to hiring and retaining talent?
We are constantly changing and evolving our hiring. We have developed a very attractive firm, strong culture, and invested heavily in marketing and talent to tell our story better through multiple means; personal, social media, and videography to name a few. It is working. Our Talent Engagement team has a marketing background, and from that we focus heavily on staff referrals and building personal relationships. Our Human Resources group is somewhat separate from Talent Engagement. The Human Resources team maintains competitive benefits and other employee welfare focus.
As a multidiscipline firm working across many services and markets, where have you seen the most promising opportunities for growth?
ISG is located in the upper Midwest, but we perform work nationwide. As a true multidiscipline firm serving many markets, we believe it is very important to understand our geography’s core economy. From there, we provide service to those markets which keep that economic engine humming, such as food & beverage, industry, K-12 education, and agricultural drainage and then the markets that are needed (public works, civic/culture, residential, etc.) to support those primary economies. Fortunately, our core economy is generally food and agriculture based, and those are always necessary.
ISG is 100% employee-owned through an ESOP. How has that been a competitive advantage?
The ESOP culture is one that we had prior to becoming one, so the transition has been very easy. Being an ESOP, and wanting to communicate its virtue has been focal in our communications with current staff, prospective employees, and acquisition targets. In all three of those camps, it has been advantageous; current staff have great pride in what they have grown and want to stay to see where it goes, prospective employees see it as a very real retirement plan option, and acquisition targets recognize that they are going from one ownership position to another. We have been told that becoming an ESOP will amplify the current culture you have, and we believe that to be true.
You have made select acquisitions of architecture and engineering firms as means of growth? What do you typically look for in target firms?
Since our first acquisition in 2012, only 25% of our growth in staff has been through acquisition. The primary factors we look at when considering an acquisition are; geography, specialty service, strength of clients, and strength of staff. We function as a single profit center firm with a decent sized geographical footprint. For example, if we are considering a firm who has a specialty service and a geographic-centric business model, we know that we can take their specialty expertise out to the market over a considerably larger footprint which allows us to increase their business line while being more selective in choosing the client and thus more profitable than the acquisition target was before. Just recently, we executed our first acquisition with the primary intent of human resources. The acquisition target was a subconsultant service provider, and with ISG being a multidiscipline firm, we knew we would likely not retain their client base, but we wanted the people. Most of our growth is organic, and expansion geographically and/or acquisition is often to provide aspirational opportunities for our emerging leaders.
What are your plans this summer for rest and relaxation?
I coach my youngest son’s 13 year old travel baseball team. We are in the midst of weekend tournaments now, but our state tournaments will be over in late July. Hopefully, we can work in a few long weekends here and there. Another local business person and I bought a Northwoods League Baseball Team, the Mankato MoonDogs. We have been watching several of those games at our recently renovated, ISG designed, ballpark, but would love to catch more games on the road.
How has EwingCole’s performance fared so far in 2018?
We have experienced a great first half of 2018 and are extremely busy and have been growing in almost every office location and market. We are experiencing our second year in a row of double-digit growth. We continue to see excellent project opportunities and expect to remain busy well into 2019.
We have implemented several new methods for identifying new candidates and some have proven to be very effective. Our retention strategies continue to evolve; however, we historically maintain very good retention metrics. We have always placed a high value on professional development and employee benefits. We have expanded our human resources team and continue to evolve this to meet the expectations of the newer (younger) workforce.
As a multi-studio design organization working across offices nationally, where have you seen the most promising opportunities for growth?
For EwingCole, we see the most growth opportunities in the southern and western US. Nationally, our most significant growth is in the Science and Technology market, although we have also seen regional growth in our other core sectors such as Healthcare and Academics. We are continually assessing these opportunities; however, it comes down to servicing our national clients in the locations and the industries they require.
What are the biggest concerns your clients face today?
This varies widely by market sector and by client. One consistent theme is prioritizing needs, so they make the right long-term decisions for their facilities while limiting upfront expenditures. This decision-making process can be somewhat paralyzing for some organizations.
How can the architecture profession better convey its value in terms of differentiation, acumen and fees?
First, I think as an industry, we need to exercise a bit more self-control and discipline. We are all too quick to adjust fees, or pursue opportunities with selection processes that may not be in our overall best interest. We have seen that turning down certain opportunities has focused the attention of some of our clients in a positive way. It also creates an opening for a candid dialogue of where we can provide the most value. It’s simpler than anyone wants to make it. Find clients who value quality of service – and then provide it – consistently.
What are your plans this summer for rest and relaxation?
We just returned from a two-week family trip to Italy, so our big adventure for 2018 is behind us, although we had a wonderful time and the kids got quite an education. For the rest of the summer we will make as many long weekend trips down the Chesapeake Bay as we can. We like to visit St. Michael’s, Rock Hall, and Annapolis by boat and unplug from emails, iPads, Xboxes, and any other intelligence draining electronic device.
How has SAM’s performance fared so far in 2018?
I am pleased to note that our performance to date is very positive. We have surpassed our revenue plan for the first half of the year by 10% and compared to the same period in 2017, we experienced year-over-year growth by 30%. Our strong performance is driven by the development and expansion of our core end markets. We currently have the best balance of market diversification in the company’s history. We remain optimistic we will meet or exceed our 2018 revenue goals and continue to see strengthening of the business through the successful execution of our strategic initiatives.
Given tight labor markets for surveying and engineering professionals, have you had to change your approach to hiring and retaining talent?
The unemployment rate has been low for quite some time, so we have had to get creative and explore new ways to attract and build our talent pipeline. Our social media campaign allows us to share our company’s culture, core values and branding to prospective candidates. Through this initiative, our employees are more engaged, and we continue to build brand ambassadors internally, while gaining brand recognition, externally. We have also implemented new programs such as SAM’s Veteran Hiring Program, to share our career opportunities with Veterans who are transitioning to civilian roles. We expanded our University Relations & Internship program, along with our high school STEM initiative; giving the next generation of engineering and surveying professionals the opportunity to explore jobs and roles within our firm and industry.
Our people are what make us successful, so it is important to retain them by continuing to provide best-in-class benefit programs and more importantly, opportunities to grow in their careers. This year, we invested in our learning and development program by hiring an L&D Manager whose primary focus is to build internal training programs so that employees develop the necessary skills and competencies needed to be successful in the career paths they wish to pursue.
As a multidiscipline organization working across various client sectors and offices nationally, where have you seen the most promising opportunities for growth?
In late 2016, we acquired So-Deep, Inc. to advance our east coast expansion as part of our three-year strategic plan. This move provided an extended service offering (SUE), geographic footprint and client base; through which we have been able to leverage our complete suite of services in this region. Last month we acquired Nobles Consulting Group, Inc. (NCG). The acquisition of talent and service capability across both of these organizations is unparalleled, and is allowing us the opportunity to meet our clients’ needs like never before.
New technologies have radically changed surveying tools and techniques over the last 5 years. How does SAM stay on the forefront of these developments?
Providing best-in-class deliverables as efficiently as possible to our clients is one of the keys to our success, and staying on the forefront of technology advancements is central in achieving this. We also believe that putting the most advanced tools in the hands of our employees enables them to find more efficient ways of performing their tasks, and the approach also fosters a higher level of employee engagement. We continually work to build deep relationships with technology providers in our industry in order to try and understand what the next generation of technology might look like and when it will be available. We also attend industry and technology related conferences and perform large amounts of research to understand what new advancements are being developed and how we can best implement them. Additionally, we have a group of great employees in our Applied Technology Department who work and partner with the rest of the company to find, develop, and deploy the latest in hardware and software solutions along with improved workflows in order to maintain our position as a technology leader in our industry.
You mentioned your acquisition of NGC, a surveying and mapping firm in Florida – how does their team help advance SAM’s strategic expansion goals?
We are very excited about the career and business opportunities this relationship brings for both the NCG and SAM Teams. NCG’s reputation in the Southeast is second to none, and Allen Nobles’ investment in industry education, staff, and technology has set the bar high. NCG’s team is well- respected and considered by the land surveying profession to be one of the best in the State of Florida. Their great reputation will be leveraged to deliver our full suite of services to their existing client base, and expand our geographical presence through the many untapped and under-marketed clients/opportunities that exist in the Southeast. Both firms share similar core values and cultures, and we look forward to what the future holds for the team.
What are your plans this summer for rest and relaxation?
We live in Austin, Texas, and due to its exponential growth, the city is a fast- paced environment which can be exhausting at times. My family and I love escaping to the Hill Country in Texas; things move at a much slower pace which is very refreshing. My rest and relaxation comes in the form of working on our ranch in the Hill Country. There is always grass to mow, weeds to spray and wildlife feeders to maintain. I grew up in the Midwestern U.S. working on my uncle’s grain and livestock farming operations and was able to see, first-hand, the fruits of my labor.
One of the main drivers for me entering the Land Surveying profession was that I enjoy being outside and spending time on our ranch allows me to share the love for the outdoors with my wife and three daughters. Our girls’ favorite part of the ranch is taking photographs of the wildlife and feeding the cattle. In today’s demanding business environment work-life balance is very important, and our time at the ranch helps me stay centered and focused. Early mornings on the porch allow me to enjoy a cup of coffee and reflect on the current business challenges, ways to continue strategically advancing the business, and introspecting for opportunities for personal development.
November 7-9, 2018
Ritz-Carlton Golf Resort
Click here for more details and to register.
You’ve decided to sell your house, so you fixed that broken screen door, pruned the hedges and cut the lawn. Why do those things now? Because you want to show your house in the best possible light to potential buyers to maximize its sales price. You’ve “gotten your house in order.”
Like selling a house, to effect a successful sale of your firm, you need to get that house in order, too. You want to present your firm in the best possible light to all potential buyers—external or internal—to maximize the gain from selling what you’ve painstakingly built. Although beauty is in the eye of the beholder (the buyer, in this case), and no two buyers are exactly alike, the following are five common areas of interest to buyers in which to get your house in order.
Attractive acquisition targets have a reliable and consistent history of increasing sales, revenue and profitability. This scalability is the mark of effective firm leadership and a well-run business. Buyers like to know that, once acquired, the firm and its management team will continue to drive growth, cash flow and operational excellence. After all, the buyer needs a return on his or her investment, and past performance can be an indicator of future performance.
In the due-diligence process, a buyer will ask to see many records, including financial statements, corporate governance documents, legal contracts, employment agreements, insurance documents, employee manuals and shareholder agreements. Missing, incomplete, incorrect and contradictory records make it difficult for a buyer to understand your business, which creates unnecessary risk. In this case, they will likely move on to another acquisition target, as they have limited time and many other targets to evaluate.
Before beginning the formal sales process, you must have a realistic expectation of the value of your firm, because a potential buyer will not invest the money or time to evaluate your firm for acquisition unless they believe you’re willing and able to negotiate a fair price at closing.
If you believe your business to be worth $10 million, and the market believes it to be worth $5 million, the sales process will go nowhere fast. A business valuation performed by an experienced valuation expert is a small but strategic investment to keep that scenario from happening. Not only will you get an un-biased idea of the market value of your firm from which you can base negotiations of sales price, but you also get feedback on how you can make your firm more valuable.
Processes that drive client acquisition and retention, mitigate project risk, create accountability and produce reliable financial data are key to scalability, longevity and profitability—the hallmarks of valuable professional service firms. If your processes are too dependent on you as the owner, that limits scalability, longevity and profitability in the long term. To increase the marketability and value of your firm, run it so it can run without you.
A savvy buyer (the kind you want) will be well-versed in reading financial statements. They will be looking for key components from which they can derive and apply metrics to determine the value of your firm. Financial statements that are well organized, prepared using the appropriate GAAP accounting methods, and conform to industry norms make the buyer’s due diligence process easier and faster. Conversely, messy financial statements are difficult to work with and can be indicative of problems in other areas. If you’re not sure if your financial statements are up to par, ask your CPA for help. Or, better yet, have your financials compiled, reviewed or audited, depending on your situation and budget.
Excellence in these five areas makes your firm more valuable to a potential buyer, whether that buyer is external or internal. When you think about it, the things that make a firm valuable to a buyer also make it valuable to the owner. The time and effort invested in getting your firm’s house in order for a sale will pay big dividends, whether you decide to sell the firm or retain ownership.
Join Carl in Dallas on May 8th or in Las Vegas on September 19th for our one-day Ownership Transition Strategies Seminars: http://rog-partners.com/events/seminars-events/.
I’ve spoken with countless, exasperated A/E firm owners over the years who’ve asked me why their firm’s internal valuation doesn’t reflect a number similar to what they believe they can reasonably expect from an external sale. Most, but not all of the time, they’re first generation owners who are not sure why they’re expected to sell shares internally at a discount to what they might receive on a pro rata basis if their company were to sell to an outside acquirer.
Understanding the various levels of value can go a long way in helping guide expectations for firm owners and potential owners alike, and in this perspective, I’ll provide a fundamental explanation of each level of value with the hope of demystifying some common misconceptions.
A firm’s valuation will vary significantly based on the level of the interest being valued. The differences in levels reflect the risk of achieving two things: expected cash flows and expected growth.
Starting with the highest level of value – control – a controlling interest stake affords its ownership the right to exert control over key business decisions that it believes will allow it to improve earnings and increase growth prospects. As such, there is a premium associated with what an acquirer believes it will be able to generate in terms of future cash flows and top-line growth that is represented in a control premium paid to gain those future benefits. When AECOM acquired URS in 2014, it paid $56.31 per share, a number that represented a 19% premium over the trailing 30-day average closing URS share price. This premium was what AECOM paid to gain control of URS.
The level immediately below control is marketable minority, which is the most straightforward level of value. When you purchase shares of AECOM, you become a minority shareholder of AECOM; those shares are unrestricted, which means that you have the ability to monetize those shares quickly at a marginal cost in an open market with multiple buyers and sellers. What you don’t have as a minority interest owner, however, is the ability to make any business decisions on behalf of AECOM. This lack of influence over a Company’s decision-making process is reflected in the discount for lack of control (“DLOC”). We often see DLOCs in the range of ~10% to ~30% with our clients.
But the level of interest relevant for almost all privately-held companies, especially those that have an internal market for shares – the non-marketable minority interest – dictates that yet one more discount be considered. Unlike your shares in AECOM, owners of non-marketable minority interests aren’t able to quickly convert their shares to cash without risking a significant loss in value. Publicly-traded stocks aren’t subject to this holding-period risk, while privately-held company shares are, since there is no readily available market in which shares can be transacted. Additionally, a blockage discount is a byproduct of the illiquidity associated with this level of interest. This discount may further decrease value based on whether the block of shares being transacted is so great that in order for a timely transaction to occur, the price of the shares must be discounted.
These inherent restrictions associated with a privately-held ownership interest dictate that there be a discount to reflect the illiquid nature of such an interest. This discount is known as the discount for lack of marketability (“DLOM”). DLOMs for firms (non-ESOP) we work with are generally between ~20% to ~40%.
While the basic tenets of the various levels of value apply to almost all firms, there are two types of firms I encounter regularly for which additional consideration and planning are required to ensure successful transitions, internally or externally. The first type are the firms who buck industry performance trends…in a good way, that is. Regardless of what’s occurring in local, national or global economies, their profit margins are consistently high during a downturn and even higher when the economy is booming. These firms usually see a smaller gap between what they might transact at internally versus what they might command in an external acquisition.
The other type of firm is one that relies on a material portion of its revenues from set-aside contracts. These firms, regardless of whether they’re performing below, at, or above industry medians, can quite often trade at a higher price internally than they could reasonably expect to get from an acquirer.
There is no “one size fits all” approach to determining and applying discounts or premiums. Although all shareholders benefit from the various perquisites of ownership, the extent of such benefits can vary widely, especially based on what level of value best represents their ownership interest.
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.
On December 22nd, the Tax Cuts and Jobs Act (TCJA) was officially signed into law. Among the sweeping changes were substantial reductions in the corporate tax rate from a top marginal rate of 35%, to a flat 21%, along with an elimination of the corporate alternative minimum tax (AMT). This time last year we theorized about what a potential corporate tax rate cut might mean for company valuations. But now theory has become reality, with major implications for A/E firms across the U.S.
At the simplest level, profitable firms could see an increase in after-tax earnings of approximately 22%. The tables below illustrate the change in effective combined federal and state corporate tax rates for hypothetical firms in Iowa (one of highest corporate tax states), and in Wyoming (a state with no corporate income tax).
Estimated Combined Corporate Income Tax Rate Prior to TCJA
|Combined Corporate Tax Rate (Iowa)|
|State Rate (highest marginal)||12.0%|
|Tax-effected State Rate (A)||7.8%|
|Federal Rate (highest marginal) (B)||35.0%|
|Combined Effective Tax Rate (A+B)||42.8%|
|Combined Corporate Tax Rate (Wyoming)|
|Tax-effected State Rate (A)||0.0%|
|Federal Rate (highest marginal) (B)||35.0%|
|Combined Effective Tax Rate (A+B)||35.0%|
Estimated Combined Corporate Income Tax Rate After TCJA
|New Combined Corporate Tax Rate (Iowa)|
|State Rate (highest marginal)||12.0%|
|Tax-effected State Rate (A)||9.5%|
|New Federal Rate (B)||21.0%|
|Combined Effective Tax Rate (A+B)||30.5%|
|New Combined Corporate Tax Rate (Wyoming)|
|Tax-effected State Rate (A)||0.0%|
|New Federal Rate (B)||21.0%|
|Combined Effective Tax Rate (A+B)||21.0%|
Note that the above analysis assumes a C-corporation tax structure. The effective tax analysis for pass-through tax entities, including S-corporations and LLCs is much more complex, and will be the subject of a future Perspective.
All other things being equal, increased after-tax earnings would naturally lead to a commensurate increase in enterprise value (the value of a firm before consideration of its debt and cash balances), but business valuation is a bit more complex, and other factors, such as cost of capital, public company valuation multiples, and longer term economic trends must be considered.
With respect to the cost of capital, the TCJA puts limitations on the deductibility of interest expense. However, given that the typical firm in the A/E industry is lightly leveraged, this is unlikely to be a factor in most cases. The larger consideration will be whether baseline interest rates will increase in 2018, and by how much. In the latest meeting of the Federal Reserve’s Open Market Committee, the target range for the federal funds rate was increased by 0.25%. Inflationary concerns could spur further interest rate hikes in 2018, with the ultimate effect being a higher cost of capital, slightly offsetting the impact of increased earnings on company values.
As it relates to publicly traded firms, the perfect market theory would suggest that the cash flow impact of the TCJA is already accounted for in current market pricing. This seems to be supported by the broad expansion of the U.S. stock market over the past year. The Dow Jones Industrial Average has increased from 18,259 on November 7th, 2016 (immediately prior to the election), to 24,754 on December 22nd, (the date of the tax bill signing), which equates to an increase of 35.6%. Given that estimates for the Dow’s earnings per share for 2018 over 2017 suggest growth of only 11%, the market is clearly counting on significant incremental earnings benefits from the TCJA.
With respect to the narrower sector of publicly traded companies in the A/E industry, as the chart below indicates, these firms also saw stock price growth over the last year, with much of it coming in the final quarter of the year, which corresponds with the negotiation and eventual passage of the TCJA. The firms shown below include Tetra Tech (TTEK), AECOM (ACM), Stantec (STN), Jacobs Engineering (JEC) and NV5 Global (NVEE). We note that these firms have varying concentrations of earnings in the U.S., and therefore some will benefit more than others from a lower U.S. corporate tax rate.
AEC Publicly Traded Companies Share Price Trends
The impact of longer term operational and economic trends is more difficult to gauge. Some lingering questions include:
So in short, most firms should expect a material positive impact on their fair market value as a result of the TCJA. If you establish your firm’s value through the use of a professional business appraiser, he or she should be accounting for the impact of TCJA. If you are using another method to establish your firm’s value, such as a simple formula, this might be good time to re-assess that formula.
With the country in transition settling into the dynamics and drama of a new administration, the underlying positive momentum of both the U.S. economy and A/E industry has certainly been significant. At a macro level, we’ve seen this unfold with a soaring stock market, back-to-back quarters of 3%+ GDP growth and a plunging unemployment rate. And while unleashing a major U.S. infrastructure package was not in the political cards this year, A/E executives seemed not to notice. Backlogs are up across major client sectors, hiring needs are as acute as ever, recent setbacks in oil & gas and mining activity have abated, spending on capital equipment and software has risen, and A/E consolidation rolls along. As validation, new private equity investment into a number of the industry’s most recognizable and blue-chip A/E and environmental organizations was evident.
With better visibility, at least in the short-run, growth-oriented leaders have ramped up their M&A pursuits while potential sellers have felt increasing emboldened, highlighting their healthier financial performance and overall sanguine outlook. By our research, the number of 2017 North American A/E and environmental consulting transactions will finish the year generally flat from 2016 levels. However, we feel the size and scale of activity are poised to break out in 2018, primarily driven by a massive generation of Baby Boomer owners still woefully unprepared to successfully transition their firms and unlock value for themselves.
Key A/E M&A takeaways include the following:
1. The CH2M-Jacobs merger solidifies a new global echelon of players – Many were stunned in August to hear that two of the industry’s largest and iconic names had joined forces in a $2.8 billion merger with 75,000 employees worldwide. But in fact, this combination just reinforces the incarnation of an elite number of multi-disciplined organizations, working seamlessly across markets and borders. If I had told you four years ago that CH2M, URS, AMEC, MWH Global and Atkins would all be absorbed by other global consolidators, I imagine most would have never believed it. Understandably, these tie-ups have now created deeper conversations in the boardrooms and executive suites of other sizable consulting firms. Will others be able to “go it alone” given their own size, strategic, succession and ownership/capital limitations?
2. Confidence fuels deal making – The two most critical elements needed to spur M&A activity are healthy balance sheets and executive confidence, and our industry has both today. The ACEC Engineering Business Index just reported its largest-ever quarterly increase, the AIA Billings Index has been elevated all year due to strength in inquiries and new design contracts, and the NFIB Index of Small Business Optimism remains high given owner expectations of stronger revenue, regulatory relief and expansion needs. With recruiting challenges everywhere as a limiting factor to growth, the “buy vs. build” calculus has shifted. CEOs have increasingly added synergistic acquisitions as an integral part of 2018 business plans.
3. But prosperity breeds complacency – Sadly, good times don’t last forever. While we’re currently experiencing a period of optimism and good fortunes, industry leaders need to be on alert for warning signs on the horizon. The Fed is set to raise interest rates. Markets are overheating in certain sectors (commercial, office, multifamily and lodging construction across numerous cities). More states faced mid-year revenue shortfalls in the last fiscal year than in any year since 2010. Higher wages needed to attract and retain architects and engineers risk profit margins unless productivity and utilization levels can be increased. Many owners kick the can down the road on succession planning and exit strategy thinking for another time as flush bonuses and distributions paralyze decision making.
In the context of M&A activity, buyer complacency emerges in lacking the proper valuation, due diligence, risk assessment and integration discipline. Elements of mature cycle M&A engagement often include assessing “hockey stick” financial results of targets over the last 12-18 months (is it sustainable or representative?), the increased desire of earnouts to mitigate downside risks, and contemplating future cost savings or staff redundancies should a target firm’s results suddenly decline.
4. M&A convergence of A/E professional services with technological assets – As our industry enters the 21st century, rapid scientific and technical advancements are creating exciting and revolutionary design changes in buildings, ITS/highways, power grids, energy systems, data centers and telecommunication networks, to name a few. As a result, we are witnessing an intersection of traditional A/E firms acquiring companies with unique hardware, software and product-related synergies. Great examples this year included targets specializing in: 1) data analytics for utilities; 2) water infrastructure software and modeling; 3) EHS enterprise technology and IT services; 4) advanced control systems for smart cities and industrial automation; and 5) geospatial firms with proprietary GIS/mapping software and unmanned aircraft systems.
5. The taxman cometh – While the new tax bill still has to be reconciled and finalized, to say that architecture and engineering leaders are disappointed with the changes coming out of Washington would be an understatement. Pass-through S-Corporations, which comprise the majority of A/E firms, would be excluded from lower rates compared to other businesses. We are already seeing owners crunch the numbers and assess their options, including taking a serious look at C-Corporation conversion, particularly if their firms might lose Section 199/DPAD deductions and are negatively impacted (personally) by reduced state and local tax (SALT) deductions.
Dave Sullivan, National A/E Tax and Advisory Partner at the Boston-based firm DiCicco, Gulman & Company does not see a negative impact on future M&A activity with this proposed law. However, he also does not see anything that would necessarily accelerate it. For sellers, capital gain rate changes are not on the table, and although there is limited clarity on where ordinary income rates will ultimately fall, they do not appear to be rising. For acquirers purchasing assets, there may be accelerated deductions available that would create additional cash flow during the post-transaction period. We’ll have to see where the dust settles with all of this heading into next year.
At ROG + Partners, we possess strong relationships and years of experience navigating A/E and environmental buyers and sellers through the M&A process and towards winning combinations. Whether you are seeking to grow through acquisitions or by evaluating your firm’s strategic and ownership alternatives, please contact us as to how we can help your organization.
We are pleased to have assisted our clients with the following recent M&A transactions – http://rog-partners.com/transactions-2/.
On a final note, Season’s Greetings and a happy, healthy and prosperous New Year from all of us here at ROG + Partners!
“When Alan turned 60, he announced his intent to retire at age 65. That was ten years ago.”
Alan co-founded a successful consulting engineering firm when he was in his 30’s. Over the years the practice grew steadily, adding new staff, offices, and owners along the way. When Alan turned 60, he announced his intent to retire at age 65. That was ten years ago. Now, at age 70, he still enjoys his work, and while he’s cut back on hours, business travel, and administrative duties, he still manages a significant portfolio of business. The last time someone asked when he planned to retire, he answered (tongue firmly planted in cheek), “the day after I die at my desk.”
Of course, Alan is a fictional character, but I would wager that many of our readers have one or more Alans in their firms, and may be wrestling with the challenge of how to accommodate such seasoned professionals who are both able and willing to continue in full-time employment while maintaining upward mobility for more junior staff.
An interesting demographic trend over the last decade is the aging of the working population, both in the U.S. and globally. According to the Pew Research Center, the population of people age 65 and older has been increasing both in numbers, and as a percentage of the total population since 1950, and this trend is projected to continue through 2050. Furthermore, the rate of participation in the workforce of those age 65 and older has been on the rise since 2007.
U.S. Population by Age range – Historical & Projected
When you combine the aging workforce trend illustrated above with the emergence of the Millennial generation, which is projected to dominate the workforce for the next thirty years, you get some painful pressure points. These can include:
Boomers postponing retirements AND being unwilling to hand over the reins of management can create real tension in an organization—potentially driving off the top talent below them. The best leaders recognize when it’s time to step back from their senior management roles to create that opportunity for advancement. And the best of the best will do so early enough that their successors will have a sufficient term to achieve their own vision for the firm.
If Alan can’t tell us when he plans to retire, how are we supposed to budget for his stock redemption? That kind of financial uncertainty is enough to drive a CFO crazy. The problem can be particularly acute if Alan is still a significant or even a majority shareholder. In response, we are seeing more firms incorporate mandatory divestment clauses into their governing shareholder agreements. In this way, a valued principal like Alan can continue to be employed, even as his shares are repurchased.
There’s no doubt that this is the most competitive marketplace for talent that the A/E industry has witnessed since before the 2008 recession. The best employees expect to be compensated appropriately, and the younger generations have shown themselves to be less patient than earlier generations, and less inclined to “put in their time” or “pay their dues.” Ownership remains one of the most effective ways to retain key staff and provide them with the opportunity to build real wealth for themselves through stock appreciation and profit distributions. But this requires older shareholders to be willing to part with their stock, and at a fair price.
Dealing with these challenges often comes down to the question of price. Companies that price their stock too conservatively often create a situation where shareholders nearing retirement cannot be compelled to sell because the profit distributions are simply too great, relative to the share price, to give up. On the other hand, companies that price their stock too high will find it difficult to convince new owners to invest.
Ultimately, the challenge of the aging boomers (and the up and coming millennials) may also represent an opportunity for firms to rethink roles and responsibilities, and how ownership relates to both. Stock divestment does not have to mean retirement, nor does relinquishing leadership roles, although both are necessary for ensuring the Company’s longevity. At the same time, finding new roles for those boomers that just aren’t ready to retire can be the key to preserving and transferring the wealth of technical knowledge and experience they represent.
2017 ROG Growth & Ownership Strategies Conference
If the subject of generational challenges in the A/E workplace, attracting and retaining top talent, and ownership transition planning are of interest to you, you’ll want to be sure to attend our annual Growth & Ownership Strategies Conference November 8th to 10th at the beautiful Ritz Carlton in Naples, Florida. This conference is the only one of its kind designed for A/E and environmental consulting firm leaders interested in the creation of real and sustainable value in their organizations. To learn more go to: conference.rog-partners.com.
In my experience, the top three reasons why A/E firms implement employee stock ownership plans (ESOPs) are taxes, taxes, and taxes. However, while mitigating taxes is an important element, a good ownership plan should be driven by a firm’s strategic plan and its long-term goals. An ownership plan that is exclusively focused on mitigating or eliminating taxes will rarely help a firm address its strategic goals. Strategic ownership goals might include aligning ownership with leadership, making the investment process affordable to new owners, and ensuring that the stock produces a healthy return on investment for all owners. The tax consequences of an ownership plan should be considered in the context of how they impact the firm’s ability to achieve its strategic ownership goals.
ESOPs have long been considered the panacea of tax efficiency when it comes to ownership transition, but not every firm is a good candidate for ESOP ownership, particularly if it does not address the firm’s strategic ownership goals. A few years ago, I stumbled upon an idea of creating an ownership model that has economic benefits similar to those of an ESOP, but is not as costly as an ESOP (implementation and operating) and does not require ownership to be shared with all employees. This ownership model uses common and synthetic securities with the former being valued at adjusted book value and latter having value that is similar to the goodwill value of the firm. On a combined basis, the value of these two securities will be similar to the fair market value of the company. The tax benefits of this plan can be significant – especially if your firm is very profitable. The key difference is that a shareholder will buy their shares and earn their synthetic equity.
The table below demonstrates four ownership transition scenarios and a comparison of the required cash flow to redeem the same volume shares under each scenario. These are actual metrics of a client. In the example, the company’s book value is $3.94 million, its fair market value is $10.00 million and the assumed tax rate is 40%. We have compared the economic benefit of redeeming $10.00 million of value using a direct ownership model, a 100% ESOP ownership model, a 30% ESOP ownership model, and a SRP (Supplemental Retirement Plan) model, which uses both common and synthetic equity.
The cost of redeeming $10.00 million in stock under the direct ownership model is $16.67 million, because the company has to generate enough profits to pay taxes so that it has $10 million left over to redeem the shares (net income/[1-tax rate]). Under a 100% ESOP model, the company would only have to generate $10 million in profits because at 100% ESOP ownership the company becomes a tax-free entity and is not subject to corporate taxes (the company is a subchapter S corporation). This savings significantly enhances the overall liquidity of the shares because of the tax efficiencies, which is why we have seen so many firms consider a 100% ESOP ownership model.
Under a 30% ESOP model, the company would have to generate $13.89 million in profits, paying taxes of $3.89 million in order to have $10 million remaining to redeem the shares. This explains why many firms adopt the partial ESOP ownership model. While the benefits are not as great as the 100% ESOP, is still represents significant tax savings over the direct ownership model.
Now let’s consider the SRP model. Assuming the shares are redeemed at book value and SRP units are redeemed at the difference between $10 million and $3.94 million ($6.57 million), the total cash flow required is $12.63 million. This is lower than the Direct and 30% ESOP models because the SRP units are tax deductible to the company (this security instrument takes on similar features to a deferred compensation plan). Additionally, the SRP model has some key benefits that go beyond the tax benefits described above. For example, creating an attractive return on investment is now easier because lower cash flow is required to yield greater returns. In this example, the company pays a 15% dividend on its common stock. At book value, the total dividend paid is $591,000. This makes the investment in common equity extremely attractive. Since the SRP component of this model can be a significant portion of the overall value to a shareholder, it is advisable that the SRP units vest over a long-period of time. This encourages long-term commitment on the part of the shareholders.
I will be presenting this ownership model in Los Angeles at a one-day Ownership Transition Strategies Seminar on September 19th and at our Growth & Ownership Conference in Naples this November. If you wish to understand how this SRP model can allow you to mitigate the tax consequences of ownership transition, while helping achieve your firm’s long-term goals, feel free to contact me.