In my last Perspective (November 2018), I touched on the importance of why using the “right” level of profit was important when comparing valuations of one’s firm to others on an earnings multiple basis (e.g., 4.2x EBITDA, 3.9x EBIT, etc.). Although there are various levels of profit that firms rely on for quick pricing indications, I focused solely on EBIT (earnings before interest and tax) and EBITDA (earnings before interest, tax, depreciation & amortization) for the sake of simplicity.
This prompted a number of readers to ask for specifics about exactly what the multiple was that they should be using for their firms. Some offered that they were relying on data published in our A/E Business Valuation and M&A Transaction Study, while others were basing their assumptions off of transactions that either they or their peers at other firms had been a part of in the past. As part of my response to these questions, I countered by asking a question of my own: Would you rather your firm be valued by a high or low multiple? The replies were universally consistent: all respondents desired a high multiple.
In actuality though, the greater a firm’s profitability is compared to the profitability of its peer group, the lower the implied multiple, and vice-versa. This probably seems counterintuitive at first thought. After all, why should a firm that’s found a way to deliver enviable profits be subject to a lower multiple, and why should a firm that trails its peers benefit from a higher multiple? The reason is straightforward: The inherent value realizable to an investor lies in that investor’s ability to effect change, change that results in a better-run (more profitable) firm. The value placed on control, as represented by the pricing multiple, should be higher for a firm that isn’t run optimally. On the other hand, investors would balk at paying the same multiple for a median or worse-than-median performing firm, realizing that there is very little they could to that would lead to a positive change of the firm’s performance.
If pricing indications for a group of like firms point to a pre-owner bonus EBITDA of 5.0x, that multiple reflects a result that is applicable to at or around median-performing firms from the perspective of pre-owner bonus EBITDA.
What do I mean by this? Let’s consider three firms, all generating $10 million in net service revenue. Each of the firms can be considered substitutes for one another from the market’s perspective, and the median pre-owner bonus EBITDA for the group to which these firms belong is 12%.
The first firm delivers a profit margin of 12%, meaning that the implied valuation would be $6 million. At a glance, this value indication appears to be reasonable.
|Net Service Revenue||10,000,000|
|Pre-owner Bonus EBITDA margin of 12%||1,200,000|
|Implied Valuation Based on a Median Multiple of 5.0x||6,000,000|
However, if the same multiple were applied to firms whose performance out of the range of at or around the median:
The second firm, which has a much more robust profit margin of 30%, would have an implied valuation of $15 million…
|Net Service Revenue||10,000,000|
|Pre-owner Bonus EBITDA margin of 30%||3,000,000|
|Implied Valuation Based on a Median Multiple of 5.0x||15,000,000|
…and, the third firm, whose profitability severely lags compared to its peers, would have an implied valuation of $1 million.
|Net Service Revenue||10,000,000|
|Pre-owner Bonus EBITDA margin of 2%||200,000|
|Implied Valuation Based on a Median Multiple of 5.0x||1,000,000|
The fact is that the implied valuations of the second and third firms aren’t realistic, and if such valuations actually existed in the wild, they would be considered significant outliers. In the case of the second firm, an investor would question the sustainability of a profit margin so much greater than the median, resulting in a downward adjustment of the multiple based on factors specific to said investor. The third firm, while falling behind the industry by a large margin, would present an opportunity for an investor to extract greater profitability than a measly 2%, meaning that the multiple paid should be higher than the median of 5.0x.
Profit multiples offer a handy way to provide firm owners with a rough estimate of value, but what constitutes an appropriate multiple should always be given ample consideration. One way of counterbalancing the misapplication of a multiple would be to rely on a range of multiples, which can be a useful way of estimating the high and low ends of value.
Companies often say they’re client-, design- or employee-focused. The purpose of identifying your focus helps to communicate how you execute business strategies with your employees, clients, competitors and shareholders. Firms employ these focused strategies to create a path for delivering value and enhancing profitability. These are excellent examples of the types of possible focus areas to consider for your company. However, do they truly capture the essence of your company?
An increasing number of engineering firms enjoy earnings before interest, taxes, depreciation and amortization (EBITDA) margins ranging from 20 to 35 percent of net service revenues. They possess strong labor multipliers of 3.4x to 3.8x (even with public clients) and utilization rates of 60 to 65 percent. You get the idea: they’re profitable, and they’re not sweatshops.
The size of these companies doesn’t matter. The number of employees ranges from 40 to nearly 700, and most of these companies have employee headcount in triple digits. The majority of these firms have multiple offices and, in some cases, operate in multiple states. So why are these companies so effective at generating healthy profit margins? I think the reason is a lot simpler than you might think.
The Secret Sauce
First I want to share a common theme I picked up on during the “Great Recession.” At the start of the economic decline, many firms rapidly reduced the size of their workforce to stem their losses. During this same period, many firms confided to me that several of their employees probably shouldn’t have been hired by them in the first place. Harsh, I know, but these same companies also told me that before the market collapse, they couldn’t find project managers quickly enough to keep up with project demands from their clients. And there it is: project managers.
My high-profit-margin clients understand that project managers are the key to driving profit margins, not the department heads, market leaders, technical/discipline leaders or even the CEO. After all, an architectural, engineering and environmental-consulting firm is made up of a collection of projects. Focus on the one thing your firm does over and over: managing projects.
Projects Before Clients
It’s my experience that architectural firms, for the most part, enjoy stronger profit margins when compared to engineering firms. I thought this was because of the nature of the work they perform, but I stand corrected. It’s now my belief that their studio business model may play a more-significant role. Many architectural firms center their business around project management of a particular type of building design, which resembles the studio model.
Engineering firms, however, tend to center business around clients. They focus on meeting the needs of the clients—not the needs of the project—by delivering their services in a client-centric manner. This focus on clients may come at the expense of profitability because your employees are likely focused only on one small part of the project delivery: the discipline of what they know. A project manager looks at the whole picture of project delivery. To deliver a more-complex suite of services to a client requires a great project manager, not a great engineer.
Everything your firm does involves leading a project for your client. The client is only concerned about you delivering the value of services needed in a timely fashion, and your project managers should function as the CEO of all their projects. The corporate division should be in the role of leading and supporting the project managers to ensure they have all the tools needed to be successful. Corporate will provide finance, accounting, business development and human resources (training, hiring, etc.). In other words, your project managers should be leveraging what corporate provides as well as directing the technical staff on project delivery.
Services may change from project to project, but how you manage those projects should be consistent. Firms enjoying EBITDA margins well above industry norms are project-management-centric organizations. They’re very particular about how they select and develop project managers. The project manager might not be the most technically competent, nor will they be required to be well versed in all aspects of engineering solutions of a multidiscipline firm, but they should possess strong business acumen.
A great engineer might not make a great project manager, just as a great project manager might not make a great engineer. The path to efficient project management should not be based on years of experience, but instead should be an exalted position based on the skills of the individual.
I reviewed some critical statistics of several of these companies that adopt this belief. The typical ratio of employees to project managers ranged from 4.82 to 5.35, so if you have 500 employees, you may only have 100 project managers, and they must lead their many projects—not manage their projects. If your project manager spends a lot of time working in their projects, it’s very likely that they’re not leading.
So how do you organize your firm to be a project-centric organization? Let’s use a multi-state, multi-office scenario as an example. The executive team will lead the regional leaders, the regional leaders will lead the project managers, and the project managers will lead the services. Keep in mind that the expertise of your service will have technical leaders: this is where you see your matrix organization formed. But now you’re leading with a project-management focus because, after all, that’s the foundation of your business: delivering projects.
Earlier this year I met with the senior leadership team at an 85-person multi-discipline engineering firm in the southeast. Coming off the best year in company history, the group felt proud of their financial success and client accomplishments and, with the possibility of a few big projects breaking their way, felt 2019 could be even better. The nine owners present were between 45 and 65 years old and had a good sense of their collective mission, culture, and values. Unfortunately, not everyone was on the same page regarding which course they should take with their ownership evolution, so I was there to help assess various strategic alternatives with them.
Underlying our discussion was a feeling that while prospects for our industry and economy were still generally upbeat, there was the reality we could also be at a mature cycle stage. As such, for some, particularly the older shareholders who have seen the ups and downs of industry waves play out over 40 years, the timing felt “right” to capture this value and implement a formal transaction. The goal was to also bring a structure of long-term sustainability and survivability for their people and clients. As with most A/E firms considering similar scenarios and challenges, there were three viable options for them.
1. Traditional Internal Transition– For the vast majority of A/E and environmental consulting firms the internal transition remains the most common form of ownership transfer. Like those at accounting and law firms, senior management cultivates the next generation of leaders and managers and subsequently sells blocks of stock to them in a coordinated manner over many years. This struck a chord with several individuals at the meeting, particularly the younger leaders coming into their own, who enjoyed their independence and possessed a desire to perpetuate the firm’s legacy. They saw minimal disruption with their clients and staff under this approach.
Fortunately, many A/E firms today are doing quite well, and growing, profitable organizations with little debt and strong cash flow can serve as a great mechanism for internal transfer programs. In fact, there are many creative ways to implement these transactions, from the company itself redeeming shares, to direct buyouts and installment notes between individuals, to hybrid deferred compensation models that could balance the needs of both buyers and sellers.
Others in the room acknowledged the need for price affordability but believed this plan would generate the lowest value to the senior shareholders who felt they were most responsible for the firm’s recent success. In addition, while the firm was on solid footing today, the prospect of assuming sizable shareholder redemption liabilities left some wary as well as taking over seven years to get fully bought out! There was a realization that the company would have to serve as a financing conduit, either through raises, loans and/or bonuses, to the next generation, potentially leaving fewer funds available for other growth pursuits and incentives.
2. Employee Stock Ownership Plan (ESOP)– Some were intrigued with implementing an ESOP, which is basically a form of qualified retirement savings plan. In fact, hundreds of A/E and environmental consulting firms have them as both an ownership transition tool and employee benefit. ESOPs are often implemented to provide a market for the shares of senior owners who have sizable concentrations of shares, to incentivize and reward all employees (ESOPs are non-discriminatory plans), and for the firm to establish a trust to make tax-deductible cash contributions or borrow money at a lower after-tax cost. Generally, we see companies around $10 million and above in revenue as the right size to pursue an ESOP, so this firm was a good candidate.
While some of the owners agreed with the powerful tax benefits and a likely higher valuation than the straight internal ownership approach, others noted the higher upfront costs of implementing it as well as a possible dilution to the remaining shareholders. And while having an ESOP doesn’t mean that other motivational arrangements like incentive compensation or stock appreciation rights go away, some felt it would be overly complicated to administer and that “there’s no going back” once it’s put in place. Some saw it fitting right in with their culture and others weren’t so sure.
It seemed there were strong opinions one way or the other on ESOPs, as many had friends at competitors using them with varying levels of satisfaction and motivational effect.
3. External Firm Sale– The final option we tackled was perhaps selling the company outright to a larger buyer. All saw the ramifications of a consolidating A/E industry with growth-oriented companies snapping up others and taking root in their region. For all their success, this firm frequently felt squeezed between those national behemoth and super-regional engineering firms with deeper marketing, recruiting and financial resources and the small, local boutiques with lower fees and focused service or market niches.
The younger owners seemed most resistant to selling but recognized it would most definitely yield the highest valuation and quickest liquidity for everyone. The entire group shared war stories of familiar deals that seemed to succeed and others that didn’t. Professional services combinations can be fragile and integrating two disparate firms with different cultures, operations, processes, clients and egos, even with the best of intentions and expectations, are fraught with risk. Some realized the thorny challenge to make the transition from entrepreneur/owner to employee in a large firm, giving up control and “having to work for someone else.”
However, the consensus among them was that they might not have the number of interested and motivated next generation of engineers and planners to make an internal transition work. While their staff in their 20s and 30s were bright, capable and eager, there was a lingering worry, whether real or perceived, that they did not have an intense desire or aptitude to become owners. Despite the compelling argument that the rate of return (stock price appreciation plus annual dividends) has proven to be a strong investment for this team of senior owners, all saw a younger group as overburdened with college debt, a zeal for “work-life balance” first, and risk-averse to their career and ownership pursuits.
* * *
Which path is the best? Obviously, not an easy decision among a group of veteran practitioners with similar, but varied timing and personal goals. And all of these options need to be carefully balanced with each shareholder’s specific tax, wealth/estate, and professional goals and situation. Many A/E owners don’t start a company with the endgame in mind, but better to be in control of your own firm’s destiny than leave it up to chance.
ROG + Partners is the only financial advisory services firm dedicated to the A/E and environmental consulting industry that offers trusted advice and experience with each of the paths described above. Whether you are seeking a valuation or evaluating your firm’s strategic and ownership alternatives, please contact us as to how we can help your organization.
Our one-day Ownership Transition Strategies Seminar scheduled for the Four Seasons Hotel in St Louis on May 8th will detail the options owners have in developing a plan that is sustainable for A/E firm owners. Click here for more details or give me a call.
As advisors to design professionals, we are often asked by owners and key executives, “How can I make my firm more valuable?” While value is in the eye of the beholder, there are some things you can do to make your firm more valuable to whomever you eventually transition your firm, whether that transition is an internal or external one. At Rusk O’Brien Gido + Partners, we call these things “value levers” because the more focus and action you place on them (pressure), the more you drive up the value of your firm.
Architects and Engineers must have a process to acquire work, do the work efficiently, and get paid. And that work must be of sufficient quality and must be delivered with excellent service to your clients. Many firms make the mistake of thinking that putting in this “ante” is all that is required to create value. While doing this will get you in the game and create average value, to create exceptional value (and get paid for it in a transition), you will need to incorporate into the culture of your firm the value levers I outline below.
Simply put, firms with exceptional value are those that are scalable, profitable, and have longevity. Let’s define those terms and look at the value levers that drive them. Please note that the value levers of a particular category can also be a value driver in the other two.
Scalability: the ability of an organization to increase its relative production capacity to respond to present and future economic conditions proactively. Investors place a value premium on firms that can show solid and stable growth. Exceptionally valuable firms demonstrate the ability to grow revenues in times of economic expansion and increase market share in times of economic contraction. Here are just a few value levers you can use to drive scalability:
Profitability: the ability of an organization to consistently and predictably generate a return to its investors of time and money. Would you rather invest in a firm that had profitability one year of 5%, then 35% the next, and then back down to 10%? Or would you instead invest in one that achieved 16% to 17% consistently? On average, over the three years, they are both achieving roughly the same profitability, but one has considerably more risk and the other shows consistency and stability. Here are some value levers you can use to get consistently better returns for your firm:
Longevity: the ability of an organization to last. Said another way, a valuable organization is one that can not only survive the inevitable ups and downs, challenges and changes in business but can flourish in spite of those. A/E firms face particular challenges in this regard and here are some ideas for you to consider:
Of course, we’ve only scratched the surface on the ways to make your firm more valuable. There are many value levers that you can use, depending on your situation. The important thing is that you begin to use these levers intentionally to increase value for you or the next owner. Hopefully, this helps, and if you would like to discuss or further explore how you can increase the value of your firm, please give me a call. You can also find me at our one-day Ownership Transition Strategies for A/E Firm Leaders Seminar in May.
Rusk O’Brien Gido + Partners, LLC recently released its annually updated A/E Business Valuation and M&A Transactions Study. Data from the sixth edition study shows remarkable stability in valuations of minority interests in privately held A/E and environmental consulting firms. As illustrated below, enterprise values as a multiple of gross revenue, net service revenue, and pre-bonus earnings before interest and taxes (EBIT) were virtually unchanged from 2017 to 2018.
|Minority Interests in Privately Held Companies||2017||2018|
|Median Enterprise Value / Gross Revenue||38.3%||38.2%|
|Median Enterprise Value / Net Service Revenue||47.6%||47.6%|
|Median Enterprise Value / Pre-bonus EBIT||3.98||3.87|
This is not too surprising given the general economic stability in the U.S., similar interest rate environment, and steady financial performance across the industry. The study shows that key financial performance metrics such as labor multiplier, labor utilization (billability) and overhead rate across the industry were very consistent from the prior year. In short, firms in the A/E and environmental consulting industry posted consistently strong financial performance, with fully utilized labor resources, good demand for their services and healthy profit margins. Anecdotally, the most commonly cited concern among firm leaders was the difficulty in recruiting and retaining talented and experienced staff.
Steady economic conditions have also continued to drive merger & acquisition activity. The volume of M&A transactions in 2018 was up considerably from the prior years. Our tracking data indicates that 311 mergers or acquisitions were closed in 2018, versus 250 in 2017 and 253 in 2016. This increase in deal activity appears to have had a slightly positive impact on deal valuations and deal structure. Our sixth edition of the study shows that median valuations as a percentage of revenue and as a multiple of EBIT both increased in 2018.
|Controlling Interests in Privately Held Companies||2017||2018|
|Median Enterprise Value / Gross Revenue||60.0%||63.0%|
|Median Enterprise Value / Pre-bonus EBIT||5.9||6.2|
Deal structures shifted slightly as well, with less “at risk” consideration in the form of earn-outs and other contingent payments. The chart below illustrates the overall breakdown of consideration paid from the latest study.
At the same time, valuations of publicly traded firms have fallen back to historical norms after a spike at year-end 2017. Valuations for many public traded firms hit a high point relative to revenue and earnings at that time in anticipation of corporate tax reform and a potential infrastructure spending bill. The following chart shows the historical enterprise value as a multiple of EBITDA for the combined 11 publicly traded A/E and environmental consulting firms (weighted by revenue levels) tracked by the study.
The A/E Business Valuation and M&A Transactions Study (6th Edition) contains ten valuation multiples calculated and broken down by firm type and detailed by statistical median, mean, trimmed mean, upper and lower quartile. As referenced above it includes data on privately held firms, ESOP-sponsoring companies, publicly traded firms, and merger & acquisition transactions. The study also contains a statistical analysis of 19 distinct financial condition and operating metrics.
The study is available for only $399 – click HERE to purchase.
With the backdrop of solid macroeconomic growth, strong financial performance and robust backlogs, yet facing the tightest labor markets in a generation, A/E owners and executives are understandably wrapping up 2018 in a cautiously optimistic mood. And while there are indeed market sectors and states facing more headwinds than others, the year can be best described as “a rising tide lifting all boats” for the industry. However, a mature economic and design/construction cycle is now exhibiting mixed signals on its future direction and leaders are anxious on the impact of rising interest rates, higher material prices, and lingering trade battles. These factors will undoubtedly test an industry still all too familiar with the extreme depths of the last recession.
And yet, there are hopeful reasons to believe Santa will be looking out for A/E firms, at least in the short-run. Wide sweeping tax reform, passed at the end of last year, is set to reduce marginal tax rates for A/E firms dramatically. For owners and companies, this has the potential to unlock vast amounts of capital to be steered towards future organic growth, capital expenditures, higher compensation, acquisitions, and internal transitions. In addition, the exciting convergence of design and technology, along with endless project demands for modernizing 21st-century infrastructure and buildings, means a reshaping of our country’s physical landscape in dramatic ways. Finally, succession planning has been in full swing the last two years, and we are witnessing a number of talented, fresh-faced CEOs and Presidents taking the reins, many with bold new ideas on leadership and strategic growth.
All of these swirling opportunities and challenges have not impacted dealmakers’ appetites whatsoever this year. Overall, the 2018 M&A market for A/E and environmental firms is the strongest we’ve seen this decade. By our tabulations, it will go down as a banner year, with the number of transactions projected up 25% over last year. Numbers like these are consistent with mature macroeconomic and industry cycles that we are witnessing now. Despite continued unevenness in the energy/oil & gas sector, we see robust volumes across all other geographies, disciplines (architecture, engineering, environmental consulting) and client/market sectors.
Key A/E M&A takeaways include the following:
1. It’s been a big year for small deals – Almost 75% of industry transactions this year involved the selling firm with less than 50 employees, the highest percentage this decade. In addition, after several years of notable mega-mergers, 2018 has been relatively quiet, evidenced by the relatively small number of ENR 500 firms that have sold. Mid-size strategic buyers, those generally with $25-$250 million in revenue and often seeking niche targets, have been on the front lines of M&A activity all year and we expect that to continue.
2. The Baby Boomers continue to check out – From our conversations with A/E owners assessing their exit strategies, we are seeing that second half of the baby boomer generation (those born in the late 1950s and early 1960s) indicating now is the right time to sell and join forces with a larger parent. They have successfully navigated their companies back to sustained profitability and have seen their personal fortunes stabilize with improvements in the housing and stock markets. They offer that while eager and talented, their younger staff members increasingly do not have the means or desire to become owners, making internal transfers difficult. The valuation multiples are there, and many don’t want to make the mistakes of the prior cycle by missing out if/when a downturn materializes. In addition, many feel the constant competition and consolidation forces shaping the industry, one moving towards larger scale, deeper resources, and full-service mentality.
3. Private equity is quietly transforming the A/E industry – During the 2000s, we witnessed the global “invasion” of Canadian, Australian and European design and consulting firms. They steadily entered the United States through M&A and changed the competitive landscape with new names and an international mindset. Today, it’s the private equity and financial investors that are acquiring and recapitalizing our industry’s most venerable organizations. In fact, today there are over 30 A/E and environmental firms partially owned by financial sponsors and the list is growing longer. Just this year we saw companies such as Kleinfelder, All4 and Montrose Environmental take on private equity while others including SLR Consulting, Apex Companies, CHA, and CLEAResult swapped one investor group for another. These “platform” investments have also been responsible for the heightened levels of transaction activity, enthusiastically acquiring other niche firms for growth and scale. Traditional A/E strategic buyers now have to compete with these groups, who often bring higher valuations, enhanced liquidity, and a story of aggressive upside growth potential.
4. Integration risks rise in a mature cycle stage – Bringing together two disparate A/E firms with differences in project management, business development, design acumen, size, and cultures is always a fragile exercise. But it’s even more challenging when the economy is running at full capacity. Disgruntled staff members unhappy with a buyer’s new bonus plan, benefits, roles, communication or operating practices have no shortage of career options and competitor opportunities to pursue. Buyers, along with the seller’s ownership team, have to work extra hard to convey the benefits of a merger, reassure nervous employees, and tout its “business as usual” to prevent disruptions and defections.
5. Talent shortages are here to stay and will further drive M&A – If there was a mantra that defined 2018 for A/E firms, it’s “We’re Hiring.” Conversations with CEOs, human resource directors, and recruiters all share the vexing inability to find the quality and number of professionals to keep up with current project opportunities. Whether it’s biologists, interior designers, surveyors, carpenters, electrical engineers or bridge inspectors, the acute labor shortage has impacted all professions in every part of the country and is constraining the growth and health of our industry. Companies continue to compete for a finite talent pool alongside energy companies, developers, government agencies, and tech firms and will require a fundamental shift in A/E recruiting and retention tactics. As a result, the “buy vs. build” strategic growth assessment will continue to shift toward mass talent aggregations and acquisitions.
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: https://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!
How often have you thought about the level of profit your firm generates and applied a multiple to that profit to estimate the value of your firm as if you were to sell it to an outside buyer? How often have you heard owners of peer firms say something to the effect of, “So and so just sold their company for 8 times earnings, so that’s what we’re going to get for our firm!”
When talking about M&A valuations, owners often think about the potential sale valuation of their company in terms of pricing multiples. A/E firm owners typically rely on multiples of “profit,” which is common for mature companies in established industries/markets for which substantial pricing data exists, but the question that must be asked when discussing multiples is, “Are we talking about profit in the same terms?” (Is this an apples to apples comparison?)
I’ve had discussions about this very topic with enough clients that I thought it might make sense for me to turn to the data to help more clearly illustrate why the question earlier about comparable measures of profit is important to understand.
To begin, I created a random basket of twenty M&A transactions that included engineering, architecture, and environmental consulting firms as the acquired parties. Focusing on EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, and depreciation/amortization), I was curious about what sort of variances existed between the implied pricing multiples (i.e. Enterprise Value / EBIT, Enterprise Value / EBITDA). Even though the asset structure of A/E firms is insubstantially affected by fixed assets, depreciation & amortization still do exist for the majority of A/E firms. For this particular basket, the median difference of EBITDA as compared to EBIT was 10.0% greater (meaning that for a hypothetical firm with EBIT of $2.0 million, its EBITDA would be $2.2 million) and the median multiples of EBITDA and EBIT were 5.64x and 6.20x, respectively.
Why was this important? Because of the unintended consequences of misapplying multiples to estimate value. If the owners of that same hypothetical firm that was generating $2.2 million in EBIT were unwittingly relying on the 5.64x EBITDA multiple, their valuation would be understated by over $1 million at $11.2 million, instead of $12.4 million. Conversely, if the same firm was generating $2.2 million in EBITDA, but the owners were mistakenly applying the 6.20x EBIT multiple, their valuation would be overstated by over $1 million at $13.6 million.
Other potential missteps we encounter with clients are derived directly from compensation issues. Owner-specific compensation vs. return on investment is the most frequent consideration that must be factored when calculating a firm’s EBIT and EBITDA. Some firm owners will take bonuses in lieu of distributions. How much of an owner’s bonus should truly be characterized as a return on investment rather than as income? In order to get as close as possible to apples to apples comparison on an EBIT and EBITDA level, it is always best to look at it from a buyer’s perspective. What are the earnings they are buying, and what expenses will continue to keep the current owners and employees around?
Only when these and other factors relevant to the comparability of measures of value have been taken into consideration, and the data your company is using (i.e. method of calculating a specific measure of earnings) lines up with the data that you’re relying on to talk about industry pricing multiples, can we begin to entertain the question: “My Company Will Sell For 5x (or 6x or 7x) Earnings… Right?”
With a huge number of baby boomer leaders preparing to retire, we are witnessing the next generation of industry CEOs being promoted to lead their firms. In fact almost every week we see press releases showcasing new A/E CEOs taking the reins from their predecessors—the evolutionary process often touted in a seamless and deliberate manner.
Unfortunately not every organization is prepared for this transition. Whether it’s the founders’ desire to hold on for control or ego reasons or simply a lack of developed bench strength, we find many A/E firms struggle with succession planning. Failure to prepare for the next leader can create lingering concerns for clients and staff and be outright debilitating if there’s a tragic or unexpected event.
For guidance on this, we turned to Robert Sher who is the founding principal of CEO to CEO, a consulting firm of former chief executives that improves the leadership infrastructure of midsized companies, including professional services firms. He has seen many effective CEO successions, but also instances where the wrong candidate, executive suite procrastination, or failure to mentor rising stars leads to setbacks and the inability to achieve peak company performance.
Why should A/E firms have a formal succession plan?
Unfortunately, we never know when our time will come, either from illness or other life surprises or circumstances. Continuity of leadership is critical. A void in leadership leaves a firm at risk, invites infighting and a power struggle, and should rightly worry clients and staff who will look for alternatives. The stronger the current leader, the more his or her absence will be felt.
Who is typically responsible for developing and implementing a CEO succession planning process?
In emerging midsized firms it is most often the CEO, who is often an owner as well. CEO succession is a piece of a larger leadership succession challenge. Every leader should have a successor in place or in development. For those firms with a board, the board should require the CEO to have a viable successor and should keep up the pressure until this is accomplished. Boards protect the interest of the owners, and not having a successor is a big risk.
In the case of an environmental consulting client, the CEO had planned carefully for succession. In addition to life insurance and setting up an ESOP, he hired a talented individual and groomed him as his successor. When the CEO had to withdraw from the business due to illness, this person stepped up, and together with other senior leaders, kept the company running and growing without any interruption, and today serves as its CEO.
When should CEOs start forming a succession plan?
They should have a succession plan as soon as they pass the startup phase. That is, unless their CEO is immortal and irrevocably enslaved as CEO of that company! Everybody is at risk for dying, including young CEOs. And any CEO can blow it (ethically or otherwise) and have to walk away, or have to tend to family matters. Maybe even more importantly, many, many AE firms are short of leadership altogether. People join the firms based on professional aspirations, not business or leadership aspirations. Having many people developing as leaders and businesspeople give such firms the capacity to keep growing. Being prepared for succession can almost seem like a secondary benefit.
What are some of the characteristics and capabilities CEOs should look for with internal candidates?
There are several I would emphasize, including: a love of leadership and business; strong emotional intelligence and good followership in the organization; excellent judgement; and proven success in leading projects or lesser management duties.
Under what conditions should a board consider an outsider as CEO?
Under all conditions. Every company deserves the BEST CEO they can attract. Being an insider does have considerable benefits, but those could be outweighed by an outside candidate. As the time nears for the new leader to step into the CEO seat, a short list must be developed. That might include many insiders but should also include outsiders in the firm’s network who would likely fit the culture and bring powerful skills, experience, and perhaps fresh eyes to the firm. Firms who only have weak internal candidates should absolutely search aggressively on the outside, and get help doing it. There are many wonderful people outside your company that could lead it well!
Based on your experiences, what are a few common misconceptions about succession planning?
There are several including that simply having a few names on a piece of paper titled, “Succession Planning” means that’s all you need to do. Another is that possible succession candidates should be kept in the dark, lest they desire the position immediately. I also see a belief that succession doesn’t require clarity and commitment as to the date when the new CEO will start (when the incumbent plans to retire). Finally, that the CEO who relinquishes the seat must go off into a corner to die. Many former CEOs in A/E firms can have new roles in the business and contribute in a myriad of ways.
Robert’s keynote presentation at the Growth & Ownership Strategies Conference is titled “How A/E Leaders Overcome 7 Silent Growth Killers” and all registered attendees will receive a copy of his latest book Mighty Mid-Sized Companies. Robert is based in San Ramon, California and can be reached at email@example.com.
In 3 weeks, nearly 200 A/E firm leaders will be gathering at the Ritz-Carlton in Naples, Florida for the annual Growth & Ownership Strategies Conference! Here’s a snapshot of the types of firms that will be there:
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.