Among the many complexities of running professional service firms, certain core foundations need to be in place to achieve operational and financial success. When we undertake engagements involving either measuring, enhancing or extracting firm value, we attempt to also look beyond the numbers to understand why an organization performs the way it does. And while the balance sheet and income statement are merely the “report cards” for keeping score, we critically assess both a firm’s daily norms and behaviors as well as recent strategic decisions that serve as indicators to influencing its objectives.
And while no two firms are the same, we’ve found the most important drivers of sustainable A/E performance are: 1) having a positive and productive culture, and 2) a leadership team that consistently makes sound decisions that lead to profitable outcomes. In other words, how a business is governed.
So what exactly is “culture” and “governance”? While both terms are tossed around frequently in understanding the context of A/E organizational and interpersonal dynamics, it may help to revisit both.
We admit that culture can be nebulous, fluid and also shaped by many factors – a firm’s size, ownership, client base, disciplines, and founder’s persona. Many A/E leaders and employees will often describe their culture to us. We hear adjectives that run the gamut from “collegial,” “family,” “controlling,” “independent,” “collaborative” to “work hard, play hard.” All are helpful to appreciate patterns, traditions and policies at a macro-level, but understanding what comprises culture requires something much more elemental.
For help, I turned to our friend Chris McGoff, founder of the strategic and management consulting firm The Clearing in Washington, D.C. Over the course of his career, Chris has worked with countless organizations, including a large number of A/E and professional service firms.
From his upcoming book, Match in the Root Cellar, Chris offers that every firm culture is real, and it’s tangible. It’s a part of the human experience, and there will always be culture around us, in every form. Cultures can be generated that inhibit performance, and cultures can be generated that propel people to perform at their absolute peak.
Chris says that those that live in this kind of culture, a Peak Performance Culture, just “click.” Everything they do, they do as one, seamlessly, so that things go fast, but they go smoothly. Big, complex architecture or engineering projects suddenly seem easy because an entire culture is geared toward the same goal, the same cause, following the same processes, and relying on each other because they know that every other person on their team has the same goal, the same thought and the same mind. That is culture. It is the best kind of culture, and it is the simplest thing in the world to define.
However, his key takeaway is culture is the line that separates the behaviors you will tolerate from those you won’t. Every time you’re with a group of colleagues, this line exists. It’s invisible, but it’s real, and if you step across it, you know it immediately. His chart below captures that essence perfectly.
And what do we mean by governance? Quite simply, it’s how leaders run the business. CEOs, presidents, principals, boards and other key individuals enact broad policies and specific decisions that they believe will best serve the interests of the firm, their employees and clients. In most cases, these are choices that leaders feel will put their company’s resources to their best use and allocation, maximize profits, minimize risks, while also adhering to specific morals, values and the mission of the organization overall.
Examples of this are: Who makes principal this year? Should we acquire other firms? How do we allocate bonuses in a down year? Is it worth cold starting an office in Florida? Could we raise our billing rates? Should we refresh our website and corporate logo? Is it better to extend our lease or look for new office space? Which clients and projects need more of our attention? Is an ESOP the best option for us?
Now, of course, every organization would love to have the best of both worlds – a strong and cohesive leadership team and a Peak Performance Culture. Unfortunately, in our experience, that dynamic can be somewhat elusive. Let me illustrate with two scenarios:
Excelsior Architects has what many feel is an enviable culture. The 180-person firm recently celebrated 75 years in business and proudly maintains a list of cutting-edge and award-winning projects across a variety of market sectors. Best practices of technical innovation, design acumen, and cultivating younger architects are traced to its origins. There is an unspoken “Excelsior Way” to business development, project delivery and ownership transition, which has led to many satisfied and repeat clients. Excelsior is highly respected by its competitors.
Recently, however, the staff feels that leadership has veered off track. Never fully recovering from the recession, there are whispers the firm’s best days are behind them. Seeking new avenues, the principals made two small acquisitions in the last seven years, neither one of which integrated well, leading to “us vs. them” turf battles. Staff openly feels management has kept on several prominent, yet unproductive principals who barely carry their billing and client weight. Excelsior’s key K-12 market experienced a downturn which caught the leadership team by surprise and led to blaming and further inaction. Two rising stars passed over for promotion left to start a competing interiors firm and management failed to appreciate the impacts on three key clients. Most of the principals are over 55 and aren’t responsive to new tactics for marketing, social media and interacting with a fresh staff of status-hungry millennials.
Or how about the opposite case? Paramount Consulting Engineers is a first generation, 65-person civil engineering firm. The founder and CEO is a charismatic individual who has assembled a hard-working and accountable management team that directly oversees its various offices and divisions. The Paramount leaders promise to “walk the talk” and openly communicate the company values of “Service, Communication, Passion, Courage and Pride.” The firm has increasingly taken market share in its core land development sector and makes strong profit margins year in and year out. Two new branch offices have been successfully started within the last 5 years.
Yet, for all its good fortune something never connects culturally. Paramount has a reputation as a “sweat shop” and turnover rates are abnormally high. Emphasis on profit and office silos has led to an attitude of sharp elbows and lack of trust in sharing resources and opportunities. Staff openly gossip while others make ego-centric promises or detrimental threats in a “sink or swim” environment. Paramount seems to be successful in spite of itself.
The ramifications of understanding culture vs. governance as distinct performance drivers are evident in many situations. With regards to succession planning and ownership transition, should the priority of new leaders and owners be as change agents or stewards of the current culture? With M&A transactions, finding compatible cultures that align is key, but equally important are the seller’s leaders who must work and remain with the combined entity. How does an A/E firm that markets itself with recognizable thought leaders and design personalities help find meaning and purpose for others to achieve self-satisfaction?
Thoughts? Opinions? What are your culture and governance like? Are both driving your firm to sustained and peak performance?
One of the largest ownership transition issues A/E firm owners currently face is the same one they faced years ago: finding a way to influence younger employees and warm them to the idea of equity ownership. Luckily, now there is much more robust qualitative (and quantitative) data available from which we can draw stronger inferences as to what many Millennials’ thoughts are on long-term employment with a single employer. And we increasingly see that this piece of the equation, once understood, leads to a much simpler path to effecting a successful internal ownership.
According to the Pew Research Center, the number of employed Millennials exceeded that of employed Generation Xers for the first time in 2015 – only one year after surpassing the number of Baby Boomers in the labor force. This rapid emergence as the dominant demographic of the employed U.S. population continues to force A/E firm leaders, owners, and managers to learn and adapt to previously unfamiliar needs, preferences, and styles when it comes to working. Because this fully-burgeoned generation of employee now comprises the majority of the workforce, their voices shouldn’t be disregarded or even taken lightly.
Millennial-related key takeaways of what I’ve learned from the past five years’ worth of due diligence, analyses, and plan implementation surrounding internal ownership transfers are these: Millennials value personal growth; interactive relationships with their superiors and coworkers alike; and democratic systems that allow them a voice. Some owners, unfortunately, struggle to understand work preferences and philosophies of their youngest employees, which leads to communication issues between the two groups, which in turn can create rifts that ultimately foster and promote the idea that changing jobs is the solution for Millennials. As a result, some not-too-positive stereotypes of these younger employees persist, especially in firms where there’s a noticeable belief that they and their peers are entitled.
How can this cycle be broken? By addressing what it is that these valuable employees are seeking. Many of the comments I hear from young non-owners include wanting to: grow and nurture the specific skills they desire (be they technical or not); fashion the customary boss/owner-employee relationship into more of a coach/mentor-student dynamic; and gain a larger voice to make their participation in the firm more meaningful than just what they’re able to produce as technical employees. Of course, these goals are usually mentioned in the same breath as “producing good work” and “keeping clients happy,” but fewer young employees view these goals as peripheral.
The A/E firm owners who do make the effort to learn what Millennials want, including what skills they want to improve on as well as the kind of work they want to be doing, have stronger relationships with their younger employees. A stronger relationship leads to a more motivated, incentivized employee who is inclined to stick around longer and work with owners in pursuing their vision of growth. Many young engineers and architects regularly express that being a part of their firms’ wider visions and growth plans would help eliminate their leeriness in terms of ownership.
Millennials seek meaning in what they do, perhaps more so than generations past, and there is a strong correlation between devoting efforts to keep them happily engaged and their longevity within a company. The old narrative relegated most young workers to positions of little input and choice, while the owners’ expectation was that remaining loyal to one firm and rising through the ranks was a given. While this isn’t quite the case anymore, there is certainly no dearth of young employees who desire to become invested, financially and emotionally in their companies. However, for Millennials to evolve and meet their growth goals, firms must provide them with opportunities to work in close collaboration with their managers. Including them in the vision of the company will reap benefits for both current and future owners.
Related news topic:
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Sometimes the movement of money in capital markets can tell us a lot about investors’ expectations for a particular stock or a particular industry. In the case of the A/E industry, there are a number of factors that are likely impacting investors’ sentiments. Will increasing rates from the Federal Reserve offset any decrease in tax rates? Will reducing regulations have a positive impact on corporate growth? Will Trump’s trade policies help or hurt U.S. based companies? Based on market’s performance so far, it seems that investors’ sentiments are favorable.
The chart below shows the trend in stock prices in the A/E industry compared to the S&P 500. From September 30, 2016 into the first week in February. The A/E Index (“A/E” – in red) and the S&P 500 Index (“S&P” – in blue), both saw declines of nearly 5% through Election Day. But on November 9th, the day after Trump was elected, the S&P increased 1% and the A/E increased 9%. The increase in the A/E sector stock index shortly after the election implies that investors felt that a Trump victory and Republican control of both houses of Congress would be good for the industry.
Through February 6th, the S&P 500 increased 6% and the A/E Index increase reached as high as 20%. The A/E index has since decreased to about 16% (as of February 6, 2017), but has still out-paced the overall broad market.
What does this mean to firms operating in the A/E industry? See Chart 2. Stock prices don’t always tell the whole story, but since the election, the S&P 500’s P/E (price/earnings) multiple increased from 16.6x on November 8th to 17.7x on February 6th – an increase of 6.6%. In contrast, the A/E firms’ P/E multiples increased from 24.1x to 29.4x over that same period – an increase of 21.9%. Again, this suggests that the markets are reacting very favorably to the new administration’s proposed agenda.
There are three critical elements of a P/E Multiple: (i) Earnings Per Share (EPS), (ii) projected EPS growth rates, (iii) and the risk of future EPS (the discount rate or required rate of return). Understanding the risks of your investment requires an understanding of the risk to your current earnings stream and its future growth expectations.
When we analyze investors’ growth expectations for the broad stock market and the A/E industry specifically, the S&P 500 enjoyed the biggest percentage increase in earnings growth potential of 21% (an increase from 3.3% to 3.7%), while the A/E industry growth expectation only changed 8.8% (an increase from 9.1% to 9.9%). This is a very important factor in your risk to future earnings. Had the A/E industry change been much faster than the overall broad market, the perceived risk associated with A/E industry returns would be much greater. Instead, we are seeing a slight decrease in the A/E industry’s perceived risk, and this decrease is the first we have observed since before the recession.
Why does this matter?
When we first started following firms in the A/E industry, the risk profile of A/E firms was generally lower than the risk profile of the overall broad market. Around the time of the last recession, this risk shifted to be much greater than the broad market. Today, while A/E firms perceived risk is still higher than the broad market, it is decreasing. If the A/E industry risk continues to decrease, the impact on values will be positive, and the investment opportunity in this sector could benefit enormously.
Of course, when it comes to the overall outlook for the U.S. economy, there are still many uncertainties, and public markets have been known for their “irrational exuberance.” Only time will tell if the trends highlighted above will continue, but so far, the outlook for the A/E industry in the U.S. seems positive.
Like it or not, with an incoming Trump administration, and Republican control of the House and Senate, we’re likely to see some significant changes in the Federal tax code in 2017. In addition to cutting and simplifying the personal income tax brackets, the incoming administration has signaled that it will propose a dramatic reduction of the Federal income tax on corporations from 35% to 15%. It has also suggested that the same cut will apply to pass-through corporate entities, such as S-corporations, LLCs and partnerships.
So what will this mean for the typical A/E firm? Notwithstanding other changes that might eliminate or limit various deductions, such cuts will mean significant cash savings for companies and their owners. It would also mean a substantial increase in company stock values.
Let’s take the example of a company generating $30 million in net service revenue and $5 million in taxable income. Under the current corporate income tax environment, such a company might be paying as much as 35% in federal income taxes, perhaps as much as 40% in combined federal and state taxes, which would equate to $2 million annually. Under the proposed corporate income tax cut, the same company would have a blended federal and state rate of 21.5%, or $1,075,000 annually (assuming state taxes are deductible).
Assuming this company’s stock is valued at 5x earnings (on a non-marketable, minority interest basis), its total equity value would increase from $15,000,000 to 19,625,000, an instant jump of $4,625,000 (5x the annual tax savings of $925,000), or a whopping 31%. I personally suspect this sort of calculus was at least part of the reason for the post-election rally in U.S. stock markets.
But before you get too excited (or concerned), keep in mind that the proposed tax cuts are just that… proposed. Concern over the impact of such cuts on the budget deficit and national debt may result in these ambitious proposals being scaled back. Furthermore, other forces may have a downward impact on values. The Federal Reserve is expected to hike interest rates in 2017, and part of the proposed tax overhaul includes the elimination or limitation of the interest expense deduction for businesses. These changes would have the combined effect of increasing a company’s cost of capital, thereby reducing its value.
Using our prior example of a firm generating $5 million in earnings with an equity value of $15 million, and assuming the company has $2 million in debt bearing interest at a rate of 4.5%, and an estimated cost of equity of 18%, its weighted average cost of capital would be calculated as follows:
|Original Cost of Capital||Interest Rate||Weighting||Weighted Rate|
|Pre-tax cost of debt||4.5%|
|After-tax cost of debt||2.7%||11.8%||0.3%|
|Cost of equity||18.0%||88.2%||15.9%|
|Weighted Average Cost of Capital||16.2%|
Assuming a 50 basis point interest rate hike over the course of 2017, and the elimination of the deductibility of interest expense, the company’s cost of capital would increase by 0.6 percentage points, as illustrated below.
|Adjusted Cost of Capital||Interest Rate||Weighting||Weighted Rate|
|Pre-tax cost of debt||5.0%|
|After-tax cost of debt (no deduction)||5.0%||12.3%||0.6%|
|Cost of equity||18.5%||87.7%||16.2%|
|Weighted Average Cost of Capital||16.8%|
All other things being equal, this increase in the company’s cost of capital would result in a $700,000 decrease in value as illustrated in the application of the capitalization of cash flow valuation methods below.
|After Tax Cash Flow||$3,000,000|
|Cost of Capital (A)||16.2%|
|Long-term Growth (B)||3.0%|
|Capitalization Rate (A-B)||13.2%|
|Marketable Equity Value||$21,409,091|
|Marketability Discount (30%)||$(6,422,727)|
|Non-Marketable Equity Value (rounded)||$15,000,000|
|After Tax Cash Flow||$3,000,000|
|Cost of Capital (A)||16.8%|
|Long-term Growth (B)||3.0%|
|Capitalization Rate (A-B)||13.8%|
|Marketable Equity Value||$20,391,304|
|Marketability Discount (30%)||$(6,117,391)|
|Non-Marketable Equity Value (rounded)||$14,300,000|
Of course nobody knows for certain what sort of changes will actually be made to the tax code, monetary policy and other external factors that might impact companies in the A/E industry. Only time will tell. But it’s important to understand the potentially significant impact these proposed changes could have on companies’ stock valuations.