“The best investment I ever made!” I can’t tell you how often I’ve heard owners in the architecture, engineering and environmental consulting industries say something to this effect when I’ve asked about the performance of their company stock. There are exceptions for sure, but this is by far the more common refrain. Still, many firms struggle with their ownership transition plans due to a lack of demand for stock among their next generation of leaders.
When a company offers stock to new shareholders, it’s competing for capital with many other investment options, such as real estate, the public stock market, government bonds, etc., and buyers often have minimal financial resources. A key to a successful ownership transition plan is ensuring that your company’s stock compares favorably to the many investment alternatives a buyer has for their limited capital.
So, is your A/E firm’s stock a good investment? To answer that, you first need to look at its return on investment or ROI. Your firm’s ROI is the sum of the dividend or distribution paid per share and the appreciation of its share price over the course of the year, divided by its starting share price.
To illustrate this calculation, let’s take the example of a firm generating $10 million in net service revenue and employing approximately 70 people. The table below shows the cash flow available to the shareholders of this representative industry firm using industry median financial performance levels as footnoted.
|Representative Median A/E Firm|
|Net Service Revenue||$10,000,000|
|Pre-tax, Pre-bonus Profit (12.3%) ||$1,230,000|
|Incentive Bonuses ||-$436,000|
|Working Capital Investment ||-$113,000|
|Income Taxes ||-$238,000|
|Cash Flow Available for Distribution||$443,000|
Based on latest available survey data, the following table details this representative firm’s return on investment.
|Beginning Market Value of Equity ||$3,715,000|
|Ending Market Value of Equity ||$3,967,000|
Median pre-tax, pre-bonus profit from A/E Business Valuation and M&A Transactions Study
Staff bonuses estimated based on median bonus per employee from 2019 Deltek Clarity industry survey
Working capital investment based on median 3-year compounded annual growth rate of 6.8% and a working capital turnover rate of 6x/year
Income taxes (combined federal and state) estimated at 30% of taxable income
Equity value based on the median multiple of pre-tax, pre-bonus profit (3.02x) from A/E Business Valuation and M&A Transactions Study
Equity value assumed to grow at the industry median 3-year compounded annual growth rate of 6.8%
In this case, an investment in this firm would indeed be very attractive relative to alternatives. For perspective, the S&P 500 produced a return of 12.8% in 2018 and an average return over the past 20 years of slightly over 8%.
|Shareholder Dividend or Distribution||$443,000|
|Dividend Return (as % of equity value)||11.9%|
|Capital Appreciation (equity value growth)||6.8%|
|Total Return on Investment||18.7%|
Of course, there are some substantial differences between investing in the public stock market and investing in a privately held A/E firm that must be considered. The first is liquidity or lack thereof. Unlike a publicly traded firm, your ability to sell your shares in a privately held A/E firm will likely be governed by a shareholders agreement. In most cases, you may only sell your shares back to the company, or to other shareholders, and only upon retirement, termination of employment or other circumstances.
Stock in a privately held firm is also considered more at risk for loss of capital than that of larger, publicly traded firms. These much larger firms tend to be much more diversified and not overly dependent on particular markets, clients, or individual employees.
To overcome the greater risk and lower liquidity, a privately held A/E firm’s ROI needs to be higher to attract investment, and based on the industry analysis above, on average it is. So why do firms still struggle with a lack of internal demand for company stock? In some cases, this may be because the ROI is not strong enough, either due to poor financial performance, overly aggressive stock pricing, or both. More frequently, however, it’s because the firm has failed to communicate how its stock has performed historically effectively.
If fairly priced, the stock in your A/E firm could very well be one of your best-performing assets. And it’s one of the very few investments that you have the power to influence.
If you’d like to learn more about maximizing the ROI of your company’s stock and creating a sustainable and successful ownership transition plan, please consider joining us in Phoenix Arizona on September 18 for Successful Ownership Transition Strategies: One-Day Seminar.
This one-day workshop will cover: