Over the years I had grown close to a well-run multi-disciplined consulting engineering firm that really seemed to have a lot of great things going for it. A mid-sized player, its diversity across various services, markets, and public and private client bases enabled it to withstand the recession much better than its peers. It was historically profitable and had a knack for consistently growing at 8-12% a year. The firm had a hard-working and humble culture, recognized for quality projects and low employee turnover. Management had initiated discussions with staff members about broadening its ownership profile and regularly reinvested profits back into training, systems, and professional development. It wasn’t without its occasional challenges or turmoil, but was a model firm in many ways.
They sold to a large buyer this year.
Obviously surprised, I later spoke with the President to learn more about their thought process and rationale. Turns out their executive team had entertained discussions from sincere suitors over the years and were quietly exploring the merits with each passing encounter. He offered that their reasons were multi-faceted: they privately worried whether their younger generation had the entrepreneurial acumen and financial means to buy out the aging senior team (which would soon be facing sizable stock redemption liabilities); they saw the potential for a good cultural and synergistic fit with an unsolicited suitor who was affording them some degree of autonomy at a “fair” price; they had growing concerns they were too small and lacked sufficient capital to compete with multi-regional and national players who were encroaching into their territory; and they felt uneasy about not having a solid leadership succession plan.
Surveys show that the vast majority of A/E and environmental consulting firms would prefer to perpetuate the organization through internal ownership transition and advancement rather than an outside merger or sale. However, for organizations big and small, and particularly those with owners who delayed or failed to implement a formal transition plan, an outside sale may be the only credible alternative.
So with that in mind, what should be your fundamental goals for a sale process or if you receive unsolicited opportunities from various suitors?
Most owners only get to sell their firm once and having a clear, realistic understanding of your goals going into the process is more than half the battle. Our experienced team has helped hundreds of A/E and environmental consulting firms of all sizes and disciplines recognize their ownership transition and exit strategy goals. Please contact me with any thoughts or observations on M&A activity of if we can ever assist your organization.
Table: Representative Transactions: October – December 2010
|MWH Global||Biwater Services, Limited (U.K.)||675||N/A||Water/Wastewater|
|Parsons Brinckerhoff||The Hallsell COmpanies (Can)||350||$52MM||Structural and Restoration Engineering, Property Condition Assessment, Green Design|
|Infrastructure Corporation of America||Florence & Hutcheson||300||N/A||Transportation and Infrastructure|
|H.W. Lochner||Bucher, Willis & Ratliff||200||N/A||Transportation, Architecture, Planning, Landscape Architecture, Environmental|
|Opus International Consultants (NZ)||Dayton & Knight (Can)||90||N/A||Water/Wastewater, Process Control and Instrumentation|
|Perkins Eastman||Ehrenkrantz Eckstut & Kuhn Architects||85||N/A||Education and Historic Preservation Architecture|
|Langan Engineering & Environmental||Treadwell & Rollo||70||N/A||Environmental, Geotechnical and Earthquake Consulting|
|Jacobs||Sula Systems||70||N/A||Systems Engineering|
|Stantec (Can)||Street Smarts||60||N/A||Transportation|
|Hill International||TCM Group||50||N/A||Construction and Project Management|
In our September 2010 issue of the ROG + Perspectives, my partner Ian Rusk discussed how ownership planning is the single most important factor to ensuring long-term business success. While there are many ownership options available, we are seeing more companies in the architecture, engineering, and environmental consulting industries implement employee stock ownership plans (ESOPs).
There are two contributing factors driving the increasing number of ESOP companies. First, in 1998, Congress enacted changes to the tax code that paved the way for S-corporations to sponsor ESOPs. This was a significant event because by 2009, S-corporations accounted for as many as 40% of all ESOP companies. We believe that a major contributing factor to this shift is the fact that most professional service firms choose the S-corporation structure because of its pass-through tax benefits. Secondly, the increasing number of business owners nearing retirement age has created a market where the supply of shares in closely held companies is exceeding the demand for such shares. This has forced many companies to implement ESOPs in order to make up the shortfall.
Currently, there are more than 13 million employees participating in ESOP plans with assets of more than $928 billion. The National Center for Employee Ownership list of the top 100 employee-owned companies includes 20 companies from the A/E and environmental consulting industry.
An ESOP is a defined-contribution plan that’s designed to invest primarily in a qualifying employer’s securities. An ESOP is very similar to other retirement plans, such as 401(k), 403(a) and 403(b) plans, where the employer makes contributions on behalf of its employees. All ESOPs are governed by the Employee Retirement Income Security Act of 1975 (“ERISA”). When employees participate in an ESOP, they are not technically shareholders; they are beneficial interest holders in a trust, which in turn owns stock in the sponsoring company. The subtle difference between a direct shareholder and a beneficial interest holder is very important. Participating in an ESOP does NOT give an employee managerial authority or a role in corporate governance. Instead, the ESOP participants’ interests are represented by a trustee or fiduciary appointed to represent the ESOP.
Often ESOPs are used to purchase a large block of shares held by a departing owner of a closely held company. In some instances using an ESOP will enable a departing shareholder to cash out, maintain control of the company for a period of time, and facilitate succession. Secondarily, ESOPs are used to align all employees’ interests with those of the direct shareholders. Since most companies in the A/E and environmental consulting industry generally restrict ownership to “active” employees, implementing an ESOP is a popular option for transitioning ownership because it allows companies to ensure a consistent corporate culture and business philosophy by keeping the existing management team intact.
How can you make an ESOP work for you?
Understanding the limitations of an ESOP is essential to maximizing the benefits of an ESOP. First and foremost, you should promote your ESOP as a benefit plan. Too often we hear of companies using their ESOPs as a recruiting tool by telling job candidates that they will have an ownership stake through the ESOP. Employees who are led to believe that participation in the ESOP plan is equivalent to being a direct shareholder are likely to be disappointed and fail to appreciate the real virtues of the ESOP.
Companies with successful ESOP programs tend to characterize them as employee benefits just as they would their 401(K), health insurance and other benefits. This reduces confusion with any “direct” ownership plans that the firm may also offer. The failure to distinguish between the two (direct ownership and ESOP ownership) may lead to disappointment with the rate of wealth accumulation within the employee’s ESOP account.
Based on our anecdotal evidence, we’ve found that 100% ESOP-owned companies are uncommon in our industry. According to NCEO, the median percentage ownership of closely held ESOP firms is 30%-40% of the sponsoring company’s total outstanding stock. Most firms find that key employees respond more positively to direct ownership than to ESOP ownership because they have the ability to acquire more meaningful ownership interests than would otherwise be allocated to them in the ESOP (ESOP shares must be allocated to ALL qualified employees using a non-discriminatory formula).
If your ESOP is in its early stages of implementation, be honest with your employees as to why you’ve chosen the ESOP option. Communicate that the purpose of the ESOP is to ensure that selling shareholders are able to monetize their investment without having to sell the company. More than ever, employees want to feel secure, and keeping your company intact and independent adds to that sense of security. Also make sure that the next generation understands the obligations that the ESOP will bring. These include repaying ESOP debt (if any), and managing ESOP redemption liabilities.
Once implemented, don’t let your ESOP become stagnant. Many companies make the mistake of ignoring their ESOP once it has completed its initial acquisition of shares and repaid any associated debt. This eventually results in two groups of employees—the “haves” and the “have-nots.” Those that joined the firm before the initial ESOP transaction will have substantial ESOP accounts, while those that joined the firm afterward will have little to nothing in their accounts.
We once consulted with a large A/E firm with an ESOP that had been in place for about ten years. When we examined the plan we discovered that 20% of the employees held 80% of the beneficial ownership. As a result, the newer employees placed little value in the ESOP because it provided no meaningful benefit to them. This firm needed to breathe new life into its plan by “recycling” shares from retiring employees into the plan, thus allowing new employees to accumulate value in their ESOP accounts.
Leverage the Tax Benefits
For the employees, ESOPs allow for the deferral of taxes, not the avoidance of taxes. Far too often companies consider the implementation of an ESOP because they think they are “avoiding” taxes. If only this was true. Still, the ability to defer tax obligations is a significant one. As previously mentioned, an ESOP is a benefit plan in which the taxes to the employees are not realized until the employee takes a distribution.
Often, companies will buy back ESOP shares from retiring employees (instead of the ESOP trust buying back the shares) in order to manage the ESOP’s ownership interest and preserve its capacity to redeem the shares of a large direct shareholder in the future. One of the benefits of an ESOP is the ability to use pre-tax earnings to buy stock. If a company were to use its ESOP to purchase $500,000 of stock from a retiring employee, it could save up to $200,000 in taxes.
An ESOP can also be a great tool for financing acquisitions of other companies. For example, if a company were to acquire another company for $2,500,000, it would need to generate pre-tax income of $4.2 million to fund the acquisition. However, using an ESOP to acquire the company can provide two benefits; a tax savings of $1 million for the buying firm, and the potential for the seller to defer capital gains tax by taking advantage of the 1042 rollover benefit. The tax savings in such a deal are so substantial that the seller might be willing to consider more favorable terms or even accept a lower price. After all, it’s the after-tax proceeds that matter.
So, if you want to ensure a successful ESOP, remember the fundamentals: Why, What and How. Why? The essential purpose of implementing an ESOP is to create liquidity for the shareholders in a tax efficient way, while simultaneously providing a new employee benefit. What? The ESOP is a benefit plan, NOT an ownership plan. The employees do not buy the shares themselves, they are contributed to them by the company as a benefit. How? Recognize that the ESOP is an extremely tax-effective tool for managing share redemption obligations and acquiring other companies.
Going forward, we expect more companies to implement ESOPs to manage their ownership transitions. Unfortunately, we also expect some companies to terminate their ESOPs because they never fully understood their potential and failed to manage their plans as they manage other aspects of their companies. Over the years, we’ve helped many companies implement ESOPs, reenergize them, and when necessary, terminate them. If you’re considering an ESOP, or having difficulty with an ESOP you already sponsor, please contact us.
The architecture, engineering and environmental consulting professions are “people” businesses. There’s no getting around it. Long-term business success is built upon attracting and retaining the right kind of people—people with technical skills, project management skills, people management skills, marketing and business development skills and perhaps most importantly, the ability develop a strong rapport with clients. Firms that cannot attract and retain such key employees will at best find themselves on a perpetual treadmill, working hard but never actually moving forward (and likely to move backward if they miss a step).
While there are many aspects of a firm’s workplace that make it an attractive home for key employees, nothing is more critical than the opportunity to become an owner. The people you need to build and sustain your business are not the sort that will be satisfied with being a wage earner and order taker. You need people that want to be owners, people that are willing to invest their own savings in the company and aspire to real leadership roles. And if you’re lucky enough to have attracted such people to your firm already, you better start making the promise of ownership a reality if you want them to stay.
Trust me. I’ve had first hand experience with owners that hoard all the equity for themselves (often out of insecurity and a fear of having “partners” to whom they might actually have to be accountable themselves). These owners often try to retain their key people with various incentive compensation plans or worse, chain them to the firm with non-compete agreements. These approaches more often than not fail in attracting and keeping A-level talent. Instead these “keep all the equity for myself” owners end up surrounded by sycophants—“yes-men” and women without an entrepreneurial bone in their bodies. This is not a recipe for long-term success.
Ownership as a Retention Tool
On the other hand, the most successful firms I’ve had the pleasure of working with have had widely distributed ownership, often with a ratio of owners to total staff of 1:10 or higher. Furthermore, these firms have structured their ownership plans to closely correlate the level of an individual’s ownership with their level of leadership within the firm.
To be clear, when I’m talking about ownership, I’m talking about direct share ownership, not ownership through an ESOP, or so-called synthetic equity (phantom stock or stock appreciation rights). These tools have their place, but they are not a substitute for direct share ownership when it comes to attracting and retaining top-level talent. Creating such instruments or even alternate classes of stock (e.g. non-voting shares) without good reason for doing so can reduce the effectiveness of your ownership plan as a retention tool.
I prefer that quote from Henry David Thoreau over the crasser version—“keep it simple, stupid,” but either will do as a philosophy when it comes to ownership planning. Just as I eschew complex synthetic stock instruments, I have a strong preference for simple, easy to understand ownership plans. Simplicity and transparency should flow through all elements of your ownership plan and philosophy, from corporate documents and shareholder agreements, to the way you value your stock and the information you share with employees. Don’t forget that you are typically dealing with financially unsophisticated investors. A plan that is easy to understand will inspire confidence. One that is overly complex will arouse suspicion.
For example, a nice, simple shareholders agreement will cover the events that should trigger the redemption of an owner’s shares (retirement, termination of employment, death, disability, etc.). It should detail the terms of repurchase (how much with cash, how much with a note payable, the rate and term of the note, etc.). It should also specify how the stock will be valued. A twenty page agreement is probably sufficient. A two hundred page agreement will send potential owners running for the exits.
A different take on non-competes
Here’s where you can employ an approach to discouraging competition. Rather than having non-compete language in your shareholders agreement or a separate non-compete agreement, you might instead include a provision in your shareholders agreement that states that a shareholder who leaves before retirement and chooses to compete directly will suffer a penalty of some sort when their shares are redeemed. That penalty could take the form of a reduced valuation, extended repurchase terms, or both.
I like this approach much more than the traditional non-compete agreement. To begin with, it does not unfairly restrict the individual from earning a living. It simply requires them to leave money on the table if they do. Also, it does not require the same effort and legal expense to enforce as a non-compete agreement does. In a way, it’s self-enforcing. And let’s face it, do you really want employees in your organization that are unhappy and want to leave, but are staying only because they are bound by a non-compete agreement? Of course not.
“Plans are nothing, but planning is everything.”
This Eisenhower quote rings true when it comes to ownership planning. The process of planning requires you to think about your organization, its potential for growth and its future financial performance, the people you employ, and the personal objectives and retirement horizons of all parties. The exercise is a very valuable one, but the road map you create will have a short shelf-life. Your ownership plan will need to be re-visited periodically and course corrections will have to be made.
The process we employ involves interviewing all parties (current employee-owners and prospective employee-owners) to understand their personal objectives and their feelings about investing in their employer’s stock. We’ll conduct a thorough analysis of the company and its financial performance to better understand the value of the stock, and the ability of the company and its cash flow to support future stock transactions (i.e., the redemptions of shares from exiting shareholders and the financing of stock purchases by aspiring shareholders). All these factors are assembled into a 10-year (or longer) projection of the firm’s financial performance, the resulting change in stock value, the stock transaction activity over the forecast period, and the impact of the related financing.
This sort of ownership planning exercise has never been more important than it is today. The simple age demographics of the US indicate that over the next five years there will be a significant turnover in ownership as baby-boomers retire. Complicating this is the fact the generation immediately following the “boomers” is much smaller. This puts more stress on ownership transition. Forecasting and planning is the key to managing major redemption liabilities.
Source: National Center for Health Statistics, Centers for Disease Control and Prevention
The consequences of NOT planning
Firms that fail to plan adequately for ownership transition will face some tough decisions. Owners of such firms will likely have difficulty attracting and retaining the next tier of leaders and owners. As a result, they will see an erosion of their equity value due to the limited internal market for their shares. They may be forced to sell externally (i.e., to another firm), but without a strong second tier of leaders, finding a strategic buyer could also prove challenging.
Ultimately I predict that the architecture, engineering and environmental consulting industry will see a significant number of firms simply close up shop over the next decade. But your firm doesn’t have to be one of them. We’ve helped hundreds of firms in the industry develop ownership plans that will sustain them through this demographic shift and ensure their long-term success. We’d be happy to discuss how we can help your firm do the same.
As we look back at the summer of 2010, its clear many CEOs, CFOs and other A/E dealmakers probably took little time for beach vacations, fishing trips or golf outings, but instead found themselves negotiating and closing transactions at the most active pace since the first half of 2008. More notably, this summer’s M&A climate has been distinguished by heightened activity from publicly traded multi-disciplined firms as well as some very intriguing cross-border transactions among global organizations (see Table). In addition, a range of factors have driven the motivations of sellers in today’s climate.
This summer’s M&A highlights include:
So what are we to make of this sudden, accelerated activity? Is this just more consolidation in an already consolidating and fragmented industry with the large getting larger? To a certain degree, that remains true. But could this activity be foreshadowing a degree of much needed incremental risk taking, heightened confidence, and overall improved future financial performance? Unfortunately, the 2010 performance of the publicly traded E&C stocks is not indicating that, with many down 5-15% since the start of the year. However, with an improved liquidity picture and global ambitions, have these larger firms become — dare we say — a bit bolder?
Many leaders and industry M&A participants we talk to indicate that yes, much of the retrenching, downsizing, and efficiency exercises of 2009 are complete and, with backlogs generally stable, that the pendulum has begun to swing back to more growth-oriented initiatives like M&A. Now certainly it should be noted that a good number of the summer’s completed transactions were ones that were sidelined, resuscitated, or just took much longer to close from last year’s frozen climate because of uncertain valuations, cloudy forecasts, and buyers’ increasingly influential demands (i.e., – increased allocations to earnouts, enhanced due diligence, stricter employment agreements, tighter working capital “true-up” and A/R adjustments, higher holdback escrows and other post-closing adjustments, etc.).
The summer also witnessed a divergence between two distinct types of transactions. The first are deals that were completed with A/E targets in relatively good financial standing, (albeit down from their lofty 2007-2008 levels) and generally in resilient areas like water and transportation infrastructure, power/energy, and environmental. The second has been with targets that have struggled, and while perhaps these organizations were not in a formal bankruptcy or 363 sale process, their recoveries have not materialized to a large degree and their outlook and survivability has become increasingly unclear. Architects, contractors, land development consultants, and targets in building bust states are several types that come to mind.
The reasons why sellers have been running to the exits are numerous, from lack of effective succession plans, to the conventional better terms/quicker exit in the external vs. internal sale, to an increasingly murky economic recovery and glum outlook on taxes and regulation for small to mid-sized businesses in general. Many owners who have had a great 10 year run and delayed a merger/sale or irrationally tried to time the market have been burned, so a good number have finally gone through with the process for better organizational clarity and direction as well.
Given the demographic shifts impacting the A/E workforce, it’s becoming evident that effective ownership transition planning, from monetizing assets and unlocking wealth to perpetuating the organization and creating opportunities for a new generation will be critical to the overall health of the design industry. We are seeing in too many cases that ownership planning needs to go beyond a one shot mechanistic formula or a static “passing the baton” moment to a continuous firm-wide evaluation that takes a holistic approach to incorporating activities such as leadership development, financial transparency, accountability, incentive compensation, and ultimately, enhancing shareholder value.
Since Rusk O’Brien Gido + Partners’ formation, our team has been in discussions with many leaders of A/E and environmental consulting firms of all shapes and sizes, covering conversations from their general business and design outlook, areas of client and market opportunity, acquisition goals/criteria, and how they’ve survived the last 18 months and what are they doing to position themselves for the inevitable recovery. We’ve certainly learned a lot from listening to others and look forward to sharing these observations and sentiments in future ROG + Perspectives. As always, please contact us if we can ever assist your organization.
Table: Representative Transactions: May – September 2010
|URS||Scott Wilson Group||5,500||$333MM||Transportation and Infrastructure|
|WS Atkins (U.K.)||PBS&J||3,500||$280MM||Buildings, Transportation and Infrastructure|
|AECOM||Davis Langdon||2,800||$324MM||Cost and Project Management|
|Cardno (Aus)||ENTRIX||615||N/A||Enviro/Natural Resources|
|Stantec (Can)||Burt Hill||600||N/A||Education and Health Care|
|Tetra Tech||EBA Engineering (Can)||600||N/A||Mining and Infrastructure|
|CDI Engineering||L. Robert Kimball||550||N/A||Buildings and Infrastructure|
|Jacobs||TechTeam Govt Solutions||500||$59MM||Government IT|
|Trow Global (Can)||Teng & Associates||500||N/A||Telecommunications/Mission Critical, Transportation, Buildings, IT/Energy Solutions|
|Michael Baker||LPA Group||475||$59MM||Transportation|