2011 Perspectives

Looking Ahead – Which Way Do We Grow?

“Behold the turtle. He only makes progress when he sticks his neck out.”
– James Bryant Conant

This year our team has spent a healthy amount of time interacting and consulting with A/E and environmental owners, executive teams and boards of all shapes and sizes on evaluating various strategic alternatives and ways to enhance shareholder value. Like a football coach drawing plays on the chalkboard, every option potentially looks like a touchdown until you actually have to play the game.

For some organizations, it’s been another year of frustratingly slow progress, of gains that come in fits and starts and the breakout momentum that rarely happens due to a never ending list of “almosts” and “shoulda beens” (e.g., fewer mega projects to pursue, key contracts still on hold, etc.). However, other firms are having a banner year of record top and bottom line performance despite a 2% GDP climate, a moribund single family housing market, federal and state budget blues, and a tougher competitive environment than anyone can remember.

Talk to leaders in the latter group and what leaps out at you is that there is no one ideal model to consistent, profitable growth. Some have grown through organic means and tighter organizational and project discipline, some via acquisitions and bold ventures, while others have benefitted from cyclical market timing and just plain luck. However, these organizations are also embracing something that has been seriously lacking over the last few years – taking risks! I’m not talking about the “bet the house” type of risk with win big/lose big ramifications, but the steadfast courage and leadership to not become paralyzed by inaction and watching competitors pass you by.

Fortunately, the A/E industry is in a healthier financial position today. Cost cutting exercises are mostly in the past and many firms are well capitalized and possess strong cash positions. Leaders seem more eager than ever to reinvigorate or maintain their growth pace. Getting your firm from here to there in this environment takes planning (of course), communication, execution, as well as a certain (healthy!) paranoia to not become complacent when things seem to be going their best.

Here are some of the growth alternatives firms are utilizing:

  • Hiring Outside Talent – For the majority of A/E firms, it’s common for management to home-grow their technical and business development talent. It creates and diffuses a culture, process and legacy for successful client relationships and project execution. Unfortunately, leadership succession is becoming a huge structural challenge for our industry and many firms will simply not have younger principals with the skills and business acumen ready and available to lead in the future. Boards are increasingly tapping seasoned outsiders to lead at the executive levels to bring new perspectives on organizational structure, marketing, and overall strategic direction.
  • Adding new service lines/market sectors – One of the biggest challenges for A/E firms is to “change your stripes” and enter completely new markets or service lines. During the height of the recession, land development firms tried to become municipal engineering experts, companies of all disciplines rushed into the federal sector, and architecture firms morphed into sustainability consultants. While much of this was done for pure survivability, adding a new service line or entering a market sector ultimately takes a much longer horizon. The risk to this diversification is that core clients can become confused, thinking you were an expert for one aspect and now you are serving a completely different base and needs. Another risk is that are you jumping into a hot sector (yesterday’s residential development could be today’s shale play?) that will inevitably cool. However, based on larger market trends or emerging client demands, certain prospects and market opportunities may appear too good to pass up. Look before you leap.
  • Opening new offices – The reality is that it has become increasingly harder to cold start new offices today. New branches are initially expensive and bring high opportunity costs without a solid client or prospects to make an easy transition. Younger principals are often reluctant to relocate to help launch an office, given that many home values are still underwater. However, the truth is that in order to grow you must have a local presence with certain types of clients, and those are hard to cultivate and service two time zones away.
  • Acquiring other firms – Of course, the alternative to the “build” approach is to buy, and many firms are ramping up their M&A initiatives, seeking targets that will help them expand quicker into new regions, markets or client bases. From our perspective, it continues to be a “buyer’s market” as demographic patterns alone have the number of net sellers of shares outnumbering either the internal or external demand for them. And while integration risk and cultural and operational differences always have to be managed, when properly executed M&A remains a powerful tool for strategic growth.
  • Revamping business development models – The glory days of the 2000s where phones would ring off the hook seem to be a quaint reminder of headier times. As the overall “pie” has shrunk for many firms, there is a premium today on taking market share away from others and that has often involved a top-to-bottom review of marketing practices for a challenging new era. Leadership teams are becoming more proactive with social media channels and outreach, undergoing new branding initiatives, and training principals and project managers on developing valuable communication and sales capabilities.
  • Implementing new ownership and incentive compensation models – Maximizing performance for some organizations has also involved a critical assessment of their ownership models and incentive compensation practices. Getting shares in the next generation’s hands either directly or through phantom stock, synthetic equity or stock options is critical to linking efforts to rewards for the firm’s top performers.
  • Selling the firm – While selling one’s A/E firm is often done primarily for ownership transition purposes, it is also viewed by many as a growth strategy. Larger firms often have deeper managerial, marketing, recruiting and financial resources to help a smaller firm grow, while leveraging cross-selling potential and other organizational synergies together.

Certainly there are other growth avenues A/E firms are pursuing. However, keep in mind that all of these initiatives require a foundation of sound firm and project management discipline, such as open book management, timely cash collection, effective client communication, and investments in new information technology. As organizations look ahead to 2013, it helps to have an “everything on the table” mindset in terms of growth possibilities in your playbook. Happy New Year indeed!

Bonuses or Shareholder Distribution — Which Should Take Priority?

Occupy Wall Street protesters rejoice! The New York Times reported this weekend that 2011’s bonuses for the top investment banks are likely to be down 15-30%. But before you shed a tear for those downtrodden bankers, reflect on the fact that the average total compensation per employee of Wall Street banks such as Goldman Sachs and JP Morgan Chase will still be on the order of $300,000, with bonuses for managing directors typically measured in seven figures.

Unfortunately, even in their best years the typical A/E firm couldn’t even dream of having such a level of discretionary profit to throw around. Median profit margins in this industry (before taxes and discretionary bonuses) tend to range between 8% and 12% of net service revenue. With a relatively modest profit pool to work with, management is often faced with a difficult decision at year end—how to divide up the pool between bonuses and shareholder distributions in a way that keeps everyone happy.

There are two primary questions here:

  1. Should priority be given to incentive bonuses or to shareholder return on investment?
  2. What sort of return on investment should an owner in an A/E firm expect?

Where should the priority be?
I’ve heard many managers, consultants and advisors suggest that incentive bonuses always be given priority over shareholder distributions. The frequent refrain goes something like, “You’ve got to reward your top performers with sufficient bonuses to continue to motivate and retain them.” There are a number of problems with this philosophy. To begin with, your top performers—the people that create real value in your organization, should be the owners. If you have good alignment between the ownership of your company and the people that create value for the company, then the question of how to prioritize profit distribution is moot. If this is NOT the case in your firm, aligning ownership with the top talent and leadership should be your first task.

Secondly, there is the matter of ownership transition planning. A frequent challenge for A/E firms is how to encourage investment by prospective owners, or further investment by younger existing owners. In order for retiring owners to be able sell their shares, the younger generation must have a healthy appetite for the company’s stock. The best stimulant for this sort of appetite is a strong return on investment. However, if profits are directed first to incentive bonuses, with whatever’s left over (if anything) going to the shareholders, you’ll never be able to provide a sufficient return on investment.

I’d also offer this observation. In companies I’ve worked for and in many client firms, I’ve seen highly valued employees resign days after receiving hefty incentive bonuses. So be careful not to assign too much value to such bonuses as a key employee retention tool.

What sort of return should an owner expect?
If we can agree that priority should be given to shareholder return on investment, then the next question becomes what that return should be. Return on investment is defined as the total amount that an investment appreciates over a period of time (e.g., a year) plus any distribution paid to the shareholders over that time, divided by the value of the investment at the start of the period. Take the example of a firm with a stock value of $10 million at year-end 2010. If the firm’s value at year-end 2011 increases to $11 million, and over the year it pays distributions to its shareholders totaling $800,000, then the shareholders return on investment would equal 18%.

Stock Appreciation: $11,000,000 – $10,000,000 = $1,000,000
Shareholder Distribution: $800,000
Total Return: $1,800,000 / $10,000,000 = 18%

The first element of the return on investment, the stock price appreciation, will be determined based on the method you use to value your stock and the firm’s performance over the year. It’s the second element, shareholder distribution, which falls to the discretion of management.

I would argue that there should be a minimum targeted return on investment, but not necessarily a ceiling. The firm’s owners have invested real money; they risk the potential loss of their capital, and sometimes they even guarantee the firm’s debt. With the potential downside risks that the owners are subject to, they deserve to enjoy the upside when the firm does well.

Various models exist for estimating required rates of return for equity investors. These include the capital asset pricing model (CAPM), Ibbotson build-up method, and other models that look to public market pricing of stocks relative to the current interest rate environment. These models typically point to a required rate of return in the 17% to 25% range. Adjusting for the lack of marketability of privately held stock (because the above models are based on data from publicly traded firms) this range increases to 22% to 32%.

For that reason we advise clients that their target return on investment should be somewhere around 30%. You may not achieve this target every year, but you might also exceed it some years. In the example above, the firm’s distribution would need to be $2 million rather than $800,000 in order to provide a 30% return to its shareholders.

Sharing the wealth
Of course management will always need to exercise a healthy degree of discretion when it comes to profit distribution, and the thinner the profit pool, the tougher the decisions will be. Profit sharing and incentive bonuses still have their place, and owners should be willing to share the wealth. Just remember that the long-term viability of your firm requires having good people that are truly vested in its success. These are (or should be) your owners and providing them with a strong return on investment is priority number one.

The Vanishing Mid-Sized A/E Firm

“We’re too big to be little, and we’re too little to be big.” – Burt Hill’s CEO Pete Moriarty on his board’s decision to sell to Stantec in 2010

Being stuck in the middle can be hard. In my mind, no one personified that dilemma better than Jan Brady, the perpetually awkward and insecure middle child on the classic TV series The Brady Bunch. On one hand, Jan was always jealous of her pretty and popular older sister Marcia, leading to unfair comparisons and inferiority complexes. And on the other, the family seemed to shower more affection on little Cindy, the sweet and talented youngest daughter, complete with her pigtails and cute lisp. If Jan wasn’t battling freckles, she was nervous about wearing glasses. As best as she tried to make a name for herself or form her own identity, Jan struggled to fit in.

You could draw similar comparisons to many mid-sized A/E and environmental consulting firms in this climate. From our vantage point, more of these “in-between” firms are struggling to fit in (and survive!) as well, leading to increasing numbers selling to larger national and international players (see table). While many leaders have sensed and observed this trend over the years, the underlying factors driving this phenomenon are unlikely to subside anytime soon.

The Middle Class
The initial question is just what exactly constitutes a “mid-sized” A/E firm, and in talking to industry leaders and experts you’ll find no shortage of opinions. Given the fragmented nature of an industry with thousands of niche practices, some define firms as “mid-sized” if they have 25 to 50 employees, particularly those that are single-discipline or dominate a particular city or region. Other companies, such as Halcrow (6,000 staff) and PBS&J (3,900), lamented their underwhelming size as motivation in selling out to industry titans CH2M HILL and Atkins, respectively. That’s a big range!

For simplicity’s sake, we’re going to define mid-sized firms as those with staff sizes between 150 and 1,500 employees. This would cover those organizations that comprise the ENR 500 up to approximately number 50. At a minimum, these firms have the following general characteristics:

  • Multi-disciplined service offerings, typically including some combination of engineering, architecture, planning and/or environmental consulting
  • Mix of public and private sector clients
  • Anywhere from 5 to 50+ office locations, with activities often dominated in one state or several regional footprints
  • Privately held, with ownership profiles ranging from sole owner to 100% ESOP
  • Formal management structures, governance policies, and IT/financial reporting systems

A/E firms above 1,500 employees tend to get exponentially larger, are often publicly owned, focus on the largest building or infrastructure projects, and have national and international franchises. Those below 150 typically tend to focus on several cities/counties in a particular geography, have higher client concentrations, fewer owners, and simpler organizational matrices.

Checking Out?
So why sell? In discussions with dozens of leaders of mid-sized organizations who sold over the last few years, the reasons they offered were the following:

  • Higher valuation – it’s common to see mid-sized A/E firms sell stock internally at book value or other deeply discounted levels as a means of affordability and simplicity. Cash-rich publicly-traded buyers have the resources to offer much higher valuations, in many cases from 5 to 8 times operating earnings and 2 to 4 times book value. For baby boomer principals whose ownership stake is often the largest asset in their retirement portfolio, better to cash out sooner rather than later. Another factor for owners – future tax rates will be going in one direction – up!
  • Ownership transition failure – the reality today is a large percentage of mid-size A/E firms have ownership profiles that defy logic. Many are “top heavy” with principals in their 50s and 60s who own a large majority of the stock. There simply aren’t enough 30 and 40 year-olds ready, willing, and able to buy these senior owners out in a coordinated process that won’t result in a decade (or more) long sell down. With profitability levels down, using the firm as a conduit to fund buyouts via cash bonuses for equity or other transfer mechanisms is increasingly difficult. More ominously, in a low growth environment, cash used to pay down redemption liabilities means less available for firm reinvestment, incentive compensation, and growth capital.
  • Leadership succession failure – hand-in-hand with ownership transition challenges are leadership succession ones. Aging A/E leaders haven’t done nearly enough to prepare and groom their next generation. Many presidents and principals look around and readily admit they don’t have faith that the next tier of managers has the capacity and acumen to guide them into the 21st century.
  • Increasing client demands – the trend in A/E client delivery models has been towards more “one stop shopping” and offering end-to-end solutions from multi-discipline planning and design through construction and monitoring. Larger firms often have the geographic coverage, broader service offerings, and business development resources that many mid-sized firms lack.
  • Diminishing marginal returns – mid-sized firm leaders voiced their frustration with the steady creeping of corporate overhead, bureaucracy, fixed costs, branch offices, governance policies, and slower decision making, all of which served to produce lower shareholder returns! In contrast, small, niche firms had lower cost structures, were more operationally nimble, and can often focus on one discipline, market segment, or geographic area more effectively.

Fighting the Tide
Fortunately, many firms aren’t quite ready to accept the inevitability of their predicament and simply get swept away with the winds of change. There are hundreds of resilient mid-sized firms who have survived through booms and busts, leadership changes, new competitors, and management fads. Recessions have a powerful way of honing the senses, and today more than ever, savvy leadership teams are challenging the conventional wisdom of business as usual as well as shaking up their firm cultures. Some of the bolder initiatives they are undertaking include:

  • Regional combinations – mid-sized firms experiencing similar growth or ownership challenges are coming together to create larger regional engineering or architecture organizations for sustainability and growth. Good examples are H.W. Lochner and Bucher, Willis & Ratliff joining forces in the Midwest, and Pennoni linking with Patton Harris Rust in the Mid-Atlantic. Architecture firm “merger of equals” are developing around common urban centers as well.
  • New ownership models – faced with sizable redemption liabilities, some organizations with conventional owner/partner models are considering new avenues, including implementing Employee Stock Ownership Plans (ESOPs) or Employee Stock Purchase Plans (ESPPs). Studies have shown that broad-based employee ownership, combined with open book management and other participative measures, can be a strong impetus to growth and profitability. Private equity is another model, where growth-oriented financial investors can help with a partial exit strategy for owners while injecting capital and business expertise to accelerate growth.
  • Intentional shrinking – most A/E firms are smaller than they were five years ago, and many significantly so. Lower project volumes have led to a combination of layoffs, office closings, divestitures, and a strategic culling of clients. As a result, many leaders offer that they are “leaner and meaner” than they have been in years and are more focused at a reduced size.
  • Get growing – for all the hand wringing and tales of woe in the A/E industry, trust us that there are a number of great growth stories taking place every day. Mid-sized firms that are “bucking the trend” are doing it through taking a critical evaluation of their business development and marketing practices, aggressively pursuing new markets and client verticals, acquiring niche firms themselves, bringing in outside talent at all levels, and taking market share away in a lower growth environment. It’s refreshing to see!

The A/E industry is going through some remarkable structural changes. The big keep getting bigger. Either displaced or just fed up, sole practitioners are putting out their own shingles in larger numbers. Design and consulting talent seems so readily available, yet so scarce. Unflinching clients are demanding more for less. The number of mid-sized firms is shrinking, but many are not going down without a fight.

Is your organization feeling a bit like Jan Brady today? Tell us what you think. ROG Partners brings years of seasoned financial and business experience in navigating A/E and environmental clients through strategic and ownership alternatives in an ever changing landscape.

Table: Representative Mid-Sized A/E and Environmental Consulting Transactions, 2010-2011

Unintended Consequences of Poor Financial Reporting

A client who called me to inquire about updating her firm’s valuation began our conversation by saying, “Not only are you going to be happy with our recent financial performance, you’re going to enjoy this engagement more than you have in the past!” Before I could express my curiosity (and perhaps more importantly, let her know I’ve always enjoyed working with her and her firm), she began singing the praises of the firm’s newly implemented accounting /project management software. Aha. Without prompting her to further explain her opening remark, I recalled our most recent project. Although highly profitable and seemingly well-organized, several cracks in her firm’s foundation had been exposed during the due diligence phase. At the time, given that many of her competitors were struggling to remain afloat, her firm remained buoyed by its high profit margins. After thoroughly working through the valuation process, we easily identified one key area that required immediate improvement: financial reporting.

Our scouring of spreadsheets and printouts a mile long revealed that while the firm’s financials were (thankfully!) prepared on a quasi-accrual basis, there was no way of easily discerning where labor dollars were being spent, what any of the non-interest “other expense” items were comprised of, or why there was no accounting for deferred tax liabilities (they’re a C-corp) – to mention only a few of the issues! The client, while briefly acknowledging the problem, countered by exclaiming, “But we’re still bucking the trend!” Nevertheless, I highlighted certain pitfalls that her firm would surely face if it continued to neglect putting forth a better effort in producing quality financial statements – she promised to look into my recommendations of software providers.

As it turns out, immediately after the engagement wrapped up, the firm made an investment in a suitable accounting/project management software suite, a decision that proved timely as revenues and profit were on the verge of a descent. During the implementation and training period, an open-book style of management was adopted and in the months following, all key managers of the business had the tools to make better decisions. Utilization, overhead rate, average collection period – these were just a few of the many metrics now trackable thanks in part to accountable financial reporting. Not completely out of the woods, yet, the firm also required debt financing at the time, the securing of which, in her words, “would have been a nightmare if we hadn’t gotten our numbers in order.”

Because most A/E firms aren’t capital-intensive, they have fewer reasons to enter into loan agreements than do firms that carry large fixed asset balances. As illustrated above, however, there is often a very real need to borrow money, and although professional service firms typically aren’t required to have a large ratio of assets-to-size, it isn’t uncommon to see them with some level of debt (various notes payable, non-compete covenants, acquisition funding, to name a few), or unreasonable to anticipate a day when borrowing will become a necessity for those who have never required it previously.

Creditors want a clear picture of the historical, current, and future cash flows and earnings of a company; the strength of the company’s asset base; and any outstanding loan agreements. The statements of income and cash flow are generally considered sufficient when gauging whether a creditor will be repaid, and the number most often focused on is EBITDA, because it highlights a company’s core profitability (by removing non-cash charges and non-operating expenses from earnings). Because of the insignificant amount of fixed assets carried by firms in our space, the two areas of a balance sheet that generally come under scrutiny are existing loan agreements and liquidity. Where a creditor will fall (senior or subordinate) to the borrower’s other debt, as well as the company’s short-term ability to meet its obligations and remain a viable entity are of particular interest to a creditor. Every bit of this type of data must be easily presentable and understandable to its intended users.

In the case of our client, the borrowed money helped get the firm through a difficult (albeit short) period, and because of improved financial reporting, the firm now has the ability to seek out areas that need greater focus before it’s too late; a benefit that might lessen the likelihood of a scramble to access capital in the future.

Banks aren’t the only external parties who rely on a company’s financial statements to make key decisions. In the stage of courtship when an acquirer gains access to a target firm’s financial statements, the quality of reporting can have a significant effect on how to further pursue the opportunity. At best, poorly presented financial statements can be a big headache for both sides, and can often lead a seller to incur additional costs related to providing satisfactory reporting. At worst, the integrity of an organization can be called into question when transparent statements aren’t available.

We recently advised a client on a potential acquisition candidate, which included providing an estimate on the fair market value of the target. Our analysis was based on less-than-ideal financial documentation, and when we requested supplementary data, were told that it wasn’t available. After discussing our findings with our client, a firm with deep M&A experience over the years not only through acquisitions, but also through divestitures, the response to our number was, “Let’s come in 25% below what we normally would’ve offered as a starting point.” I explained that our estimate of value (which was approximately 20% higher than what they intimated as their starting point) already took into account the risk associated with murky financials. The response? “We realize that. But without some sort of verification of their numbers, we don’t feel comfortable going anywhere near fair market value, given the implied risk.” Eventually, the deal broke down (due to an unrelated issue), but the lesson here had been learned – the absence of quality financial statements will do no one any favors.

There’s no good reason to engage in the practice of scant financial reporting. Preparing accurate and timely financial statements for internal AND external use should be a priority of any closely-held company’s finance/accounting team. Users of these statements should require accuracy and transparency to effectively assess financial and operational performance; poor reporting can lead to anything from a degradation of internal controls to missed opportunities for shareholders, managers, and their employees.

Constant communication of financial performance is critical to a company’s long-term success. While there isn’t a need to have financial statements audited (many of our clients don’t), they should be reviewed, or at a minimum, compiled by a CPA annually. Internally, accounting/project management software is a must for firms who need to track performance from the project level to the overall firm level.

Deferred Compensation – Know The Risk

Two decades ago a business trend caught my attention that was a foreshadowing of things to come. I was doing a considerable amount of advisory work with companies that operated in the steel industry as it was on the precipice of the pension benefit meltdown. Years later, when my former firm served as an advisor to the UAL ESOP transaction, I saw it again – the airline industry was experiencing a meltdown of legacy costs. Over the past decade, I saw the effects of pension obligations and how they impacted the financial stability of automobile manufacturers in the U.S. For every car built in Detroit, there were significant legacy costs due to ongoing pension obligations. Today, we are seeing the problems of pension obligations, and how they’re influencing the workforce. In fact, Governor Christie (NJ) has expressed the idea of converting public pensions from defined benefits to defined contributions. But what do pension benefits have to do with deferred compensation?

First, I’d like to discuss the economics of pensions and how they can affect a company’s future financial condition. Then, we’ll take a closer look at how the same can be attributed to deferred compensation plans. Companies that sponsor employee pension benefits generally do so because they believe that such benefits reduce the cost of goods and services that are tied to the overall compensation of employees. By deferring a portion of an employee’s compensation for the future, the current costs are reduced by the present value of the future liability (which is realized at the time of payment). As an example, if an employee is making $75,000, and his company promises to pay him 50% of his income upon retirement, he would effectively be receiving $37,500. Depending on the age of this employee, the actual cash outflow might not occur for decades. Furthermore, if the company were to make a contribution to this employee’s retirement plan, the investment wouldn’t be $37,500, but significantly lower. Why? Because of their expectation that initial investment and future investments will grow overtime to meet the employee’s future retirement obligations.

Trying to capture the value of the future pension obligation is an exercise in futility, because there are too many variables that impact its present value. Life expectancy after retirement can have the greatest influence on value – in other words, the longer a person lives, the greater the liability becomes. This life expectancy assumption is what is killing Social Security and Medicare. When Social Security was first implemented, the number of years the typical recipient received the pension was less than one year. Now, people are living decades past their first benefit check. Secondly, future market conditions impact expected returns, which in turn impacts the value of the plan assets. When I began developing my own personal model for retirement a decade ago, I made certain basic assumptions of my expected future returns; one primary assumption was that I could realize a 7% annual return on investment while in retirement. If I were beginning my retirement modeling in today’s climate, I believe that what I had originally assumed as my return would be flawed. In 2001, 30-year treasury notes were yielding 5.5% – today, many would be glad for 3.5%.

So, how does this compare to deferred compensation plans? Companies sponsor deferred compensation plans as part of a total compensation package for their employees – the most common plan being the 401(k). However, some firms will implement other forms of deferred compensation for a variety of reasons, the least of which includes wanting to reduce the threat of flight risk by the most valued and productive employees. Typically, these compensation plans are agreements between the employees and the company in which the company promises to pay, in the future, an amount predetermined by a formula – much like a pension. Doing so creates a liability that negatively affects the equity value of the sponsoring company, because the promise to pay the liability in the future is recorded on the balance sheet. However, the company is not required to set aside funds to satisfy this obligation. In fact, firms must exercise care when establishing a deferred plan, because if there is any guarantee of the delivery of deferred compensation, then the plan’s beneficiary has obtained constructive receipt of the deferred compensation and must recognize taxes immediately, even though he did not actually receive the funds. On the other hand, the company is able to deduct the amount of compensation that is being deferred in the year it was incurred. Why would firms do this? In addition to golden handcuffs, firms often use deferred compensation as a tool to reduce the value of equity in the company. As the value of the liability increases over time, the growth of value of the sponsoring company is limited. This means that acquiring shares by future employees becomes more affordable, and therefore will increase the likelihood of a successful ownership transition in the future.

So, why not implement deferred compensation plans? In short, whether you pay for a high value stock with no deferred compensation today, or a low value stock with deferred compensation in the future, the share purchaser will still pay for the high value. With a deferred compensation plan, a company is only delaying the inevitable, as the payment will ultimately come from company funds. Simply put, less cash means less bonuses and profit distributions.

At the crux of any promise, whether that promise be deferred compensation, bank debt, or shareholder notes, is that the obligation created today will require payments that rely on future cash flow. It may be possible to reasonably predict future payment obligations, but it’s a much more difficult task to predict future cash flow. My colleague, Ian Rusk, discussed the risk of using aggressive leverage in our August 2011 ROG + Perspective – deferred compensation is just another form of leverage that creates a strong key employee retention plan and helps manage ownership transition planning.

If Governor Christie (NJ) is proposing to convert public pensions from defined benefit plans to defined contribution plans, it won’t happen soon, but I wouldn’t be surprised if we begin seeing more public plans move in this direction. Following suit will be more companies coming up with creative ways of mitigating the flight risk of key employees, balanced with the need for feasible stock ownership plans.

Your Board of Directors May Be Holding You Back

Poorly structured and unfocused corporate governance in A/E firms both small and large is a frequent contributor to poor financial performance, lack of growth, and stalled ownership transition plans. Governance issues we frequently encounter include:

  1. Management by committee: This happens as first generation firms begin to add new shareholders and fall into the trap of giving every shareholder an equal voice in corporate governance, no matter how small their investment. Pretty soon you have the sort of gridlock that would make the U.S. Congress look efficient.
  2. Confusion over roles of managers vs. directors: When the board of directors overlaps completely with operational management, board meetings are often consumed by operational topics. The board should instead be focused on big picture strategic discussions. Directors that cannot shed their operations hat should not be on the board.
  3. Turf Protection: Related to the above, when your board includes “representatives” of every office or department, meetings often devolve into turf battles, with each representative defending their office or department, or lobbying for what they want or need, often to the detriment of the company as a whole.
  4. Not applying the best talent: Often firms choose their highest ranking, closest allies and most tenured leaders to make up a board rather than those who are the most strategic thinkers and will constructively challenge the board and bring different perspectives. And there is often no mechanism in place to continually refresh the team that comprises the board.
  5. Lack of Outside Perspective: In other industries and in larger firms, you frequently see boards made up of directors from outside the company. They might include consultants, attorneys, accounting/finance professionals, or retired executives—in other words, people that can bring unique and valuable perspective. But for some reason, most boards in the A/E industry seem to be composed entirely of members of the company’s senior management.

Gerry Salontai of the Salontai Consulting Group is the former CEO of Kleinfelder and currently sits on the boards of several successful A/E firms. According to Salontai, “The key to a great board is getting the right people as directors or advisors and focusing on the right topics. A great board will ultimately drive exceptional results for the shareholders of the firm.”

The Case Against Aggressive Financial Leverage in A/E Firms

I’ve noticed that some industry experts have recently been advancing the idea that A/E firms are under-leveraged—suggesting that firm owners should consider borrowing more from banks and other lenders because debt is a cheaper source of capital. The other logic cited is that utilizing debt capital allows an owner to finance growth without diluting their own equity interest.

My personal opinion is that this is misguided advice (at least for all but the largest most stable firms in the industry) and fails to take into account some basic characteristics of the A/E industry.

It’s true that debt is often cheaper than equity capital, and the associated interest expense is tax deductible (for now anyway). But over-leverage your A/E firm and you’re begging for trouble. Earnings can be very volatile in this industry, and professional service firms typically have very little in hard assets to collateralize a business loan. In fact, many owners must personally guarantee even the modest credit facilities they already maintain. It’s one thing to fail to make a profit distribution to your fellow owners. But default on your bank loan payments or bust a loan covenant, and you’ll be in a world of hurt.

Even moderate debt levels can become problematic when a firm is hit with an unexpected downturn or faces collections issues with its clients. Cubellis, once an extremely successful and fast-growing architecture firm, is such an example. “Speaking from first-hand experience,” says Len Cubellis “while growing my A/E firm I always felt that my leverage was safe at 70% of my receivables under 90 days. Then the world turned upside down with the Lehman Brothers collapse. Once you’re outside your loan covenants, managing your firm’s finances is no longer within your control. The bank steps in and takes steps that protect their interests first.”

There are many examples of A/E firms that had to shut their doors over the last two years ONLY because they found themselves in default with their lenders after the recession caused their revenue and earnings levels to decline. These were very good firms with solid reputations, great people, great portfolios, etc. If these firms had been capitalized less with debt and more with equity, many would still be around.
So how much debt is appropriate? Some industry statistics might be helpful here. According to a 2010 study conducted by the accounting firm DiCicco, Gulman & Company, the median total liabilities-to-equity ratio for the industry is 1.24. Other studies, such as those by the industry research and publishing firm PSMJ Resources, put this ratio at a median of 0.9. When only bank debt is included, the ratio falls to just 0.2.

There are a number of reasons for the modest levels of debt that most A/E firms operate under. To begin with, A/E firms are not capital-intensive. Without large amounts of fixed assets, there’s less need to borrow and, as previously stated, less tangible assets to use as collateral.
Earnings volatility is another factor. A/E firms, particularly smaller ones, often have highly volatile earnings levels. This is the nature of the project-based professional service industry we operate in. Debt is not a wise source of capital in a firm with volatile and unpredictable earnings due to the aforementioned default risk.

Finally, the ownership structure of most A/E firms must be considered. The vast majority of firms in the industry are owned by a small number of senior managers. In most cases, these owners must personally guarantee their company’s debt. It’s no surprise, therefore, to see these owners exhibit conservative borrowing patterns.

To grow and sustain your A/E firm you need to be willing to provide opportunities for ownership to key people. Don’t try to finance your growth by taking on debt out of a fear of diluting your equity. Apply such a strategy, and the following is likely to happen: The most talented folks you have will leave; you’ll fail to attract new talent; and you’ll ultimately be left with a 100% equity stake in nothing (or worse, you’ll owe more to the bank than your company is worth).

By contrast, if you adopt the opposite strategy and “share the wealth” you’re more likely to be rewarded with the loyalty of high-quality employees as well as the ability to attract top talent. Most owners I know would rather have a smaller equity stake in an investment of real and growing value than a 100% equity stake in a stagnant, over-leveraged business.

We’re interested to hear your thoughts on this subject, to voice your opinion, join our LinkedIn group or email me at irusk@rog-partners.com.

Mid-Year CEO Outlook



As we enter the 2nd half of 2011, we thought it was a good time to check in with 6 CEOs of leading architecture, engineering and environmental consulting firms across the country. We were curious to see how their organizations were faring so far in 2011, where they see opportunities for growth, what challenges lie on the horizon, and if their leadership styles have changed throughout this recession.  


Howard Birdsall, Chairman, President & CEO, Birdsall Services Group, Sea Girt, NJ

birdsallHow has Birdsall’s performance fared so far this year?

Our profits are up 10% from last year; however, sales are basically the same. Some of our services such as site civil, geotechnical, and traditional MEP are experiencing lower profits and sales. Services to public clients in the municipal, transportation, structural, water resources and environmental areas are relatively flat. Services in our marine and energy disciplines are growing both in profits and sales. So it’s very much a mixed bag depending on each service or market.

In what market or service areas are you seeing promising opportunities for growth?

We see opportunity in the energy market, both in renewable energy and sustainability. The other area is in marine engineering, but that’s very much a niche market. Another area is project management and design build, but to really do this effectively the risk factor goes up significantly, but so do the profits. In the long-run, we believe the health care services market will be growing due to demographics, but ObamaCare has slowed down hospital work this year. Long-term care and “out of hospital care” facilities should continue to grow. Work in the urban areas and cities will continue to grow as work in the suburbs and rural areas decline. However, our major cities are suffering from capital constraints and political challenges.

What business and/or industry challenges most concern you?

Raising prices and billing rates continues to be an issue as customers know it’s a buyer’s market. Without more job creation nationally, the “new normal” will continue for at least another 3-5 more years. For our industry that will mean lower growth and young engineers and other professionals will always gravitate to where there are better opportunities. Finding qualified people for the few areas where there are growth opportunities will continue to be a problem even with high employment. The other concern with an extended period of little or no growth will be finding employees who have enough wealth and are interested in acquiring significant ownership in the companies where they work in order for ownership transition to effectively take place.

You’ve acquired a number of firms over your career. How do you measure if a deal was successful?

First, the deal must turn out to be accretive to your net income and ultimately to your net worth. Second, the number of key people from the target who remain (the more the better) for a period of time post-acquisition, say three to five years, is critical. Third, both firms should meld together so that the culture of the new entity moves in a positive direction rather than upsetting the apple cart.

Have you had to change your style of leadership over the last few years due to the economy?

Not my style, but communication on many levels, both internal and external, has become more important for me. I’ve tried to spend more time being a good listener rather than a good speaker.

What’s on your summer reading list?

The Endgame, and Impact 2020 for business, Ted Bell books, and The Final Storm for leisure.


Kurt Fraese, CEO, GeoEngineers, Inc., Seattle, WA

fraeseHow has GeoEngineers performance fared so far this year?

We are having a very good year relative to budget and an extraordinarily good year compared to last year; generating more revenue and higher returns with fewer staff. We attribute these excellent results to the slightly better economy, focusing on our fundamentals and simplicity in our operations, keeping expenditures in check, and deploying four top managing principals back into client development and project management roles.

Since your firm serves a range of public and private sector clients, are you seeing signs of an uptick in economic activity?

We’ve seen some improvement in economic activity, particularly in the Puget Sound, Intermountain and Gulf South regions.

In what market or service areas are you seeing promising opportunities for growth?

Our energy and water/natural resources markets represent the most promising growth opportunities. Environmental, ecological, micro-tunneling, and applied technology services show promise for further growth.

What business and/or industry challenges most concern you?

The unsettled nature of the economy continues to affect confidence in the marketplace. There also is continued downward pressure on rates, more onerous contract conditions, and fierce competition. This has the potential to adversely affect our multipliers and loss prevention as well as recruiting and retention of key staff.

Have you had to change your style of leadership over the last few years due to the economy?

Yes. I have shifted my focus from strategic growth that emphasized picking the “right” markets and services to “be in” to strategic readiness with emphasis on being able to take advantage of opportunities that align with our strengths and passions. It’s a more natural path. I also have made sure to communicate with the entire firm at least once a week through an email called “Friday Focus”. The communication is an open letter to all staff and can include important market, service, training, management and philosophical news, encouragement and guidance on almost any topic.

What’s on your summer reading list?

The Big Short by Michael Lewis. It’s the true story of the early stages of the financial collapse and those who saw it coming well in advance and profited. This story is much scarier than any true crime account I’ve ever read, only it involves financial weaponry with most Americans as the victims!


Rich Bub, President & CEO, GRAEF, Milwaukee, WI

bubHow has GRAEF’s performance fared so far this year?

We saw an upturn in business during the 4th quarter of 2010. Our industrial client base started to generate work once again, our transportation market remained steady, and we continued to work on healthcare projects. As we’ve come into 2011, the industrial base has continued to improve, the transportation market remains good, higher education work is still there and commercial work related to healthcare is promising.

Since your firm works across a range of technical design disciplines and public and private sector clients, are you seeing signs of an uptick in economic activity?

There have been signs — especially from the industrial segment. The housing market continues to struggle. New jobs, always an indicator, seem to be on again, off again, with no serious traction at the present time. Given the results of budget issues at state levels, we’re watching closely for their effects at the local level.

In what market or service areas are you seeing promising opportunities for growth?

The water and energy markets. We happen to be located in an area of more abundant water supply than elsewhere in the country, so market increases here will be from companies moving into or expanding in the area who are high water users. Energy and energy management related business will be expanding regardless of where you live in the U.S. There is still a pent up market demand due to the needs of aging infrastructure. Once the challenge is met on how best to fund this type of initiative, the upgrading of the nations’ infrastructure will be a very robust market.

What business and/or industry challenges most concern you?

As a profession, our services have become more and more viewed as a commodity. The value of our expertise is never fully tapped when you have to provide the lowest cost proposal. We routinely review who we are competing with for projects and determine whether we want to provide a proposal. When all the talents of our profession are used, the best designs and results are apparent.

Have you had to change your style of leadership over the last few years due to the economy?

I believe my style of leadership has not really changed. What has occurred is I am more in need of back-up to push forward with an initiative due to the pressures on spending the capital of the firm wisely. We continue to invest in people, technology and upgrades, but they are reviewed more closely than in the past.

What are your plans this summer for rest and relaxation?

I’m a sports nut and a die-hard Milwaukee Brewers fan, so I’ll be attending a number of Brewer games throughout the summer. I also really like to golf, though my handicap is not really where I’d like it, and I’m losing distance every year. But it is relaxing, it gets me out with friends, colleagues and clients, and the laughs and fun are worth more than the score!


Ralph Hargrove, President, Hargrove Engineers + Constructors, Mobile, AL

hargroveHow has Hargrove Engineers + Constructors performance fared so far this year?

Due to our diversity in the industries we serve, and the proactive steps and investments we’ve taken to enhance our market share, we have seen an increase in business opportunities presented to us. In short, we feel we are in a good position.

Since your firm serves a range of industrial and energy clients, are you seeing signs of an uptick in economic activity?

So far, yes, and specifically in the specialty chemicals segment.

In what market or service areas are you seeing promising opportunities for growth?

Most recently, services relating to enhancing and increasing the reliability (life cycle) of our client’s existing assets.

What business and/or industry challenges most concern you?

For all the industries we serve, meeting our clients resource needs based on their expected start-up dates can always be a challenge. Having and utilizing quality planning tools and technology is critical for us.

Have you had to change your style of leadership over the last few years due to the economy?

No, not in the true sense. We have increased our training efforts to raise the bar on our technical capabilities and leadership skills of our teammates. We have made a conscious effort to distribute and disseminate the leadership throughout the company.

What are your plans this summer for rest and relaxation?

Spending as much time as possible on the Alabama Gulf Coast, enjoying all that it has to offer – boating, fishing, kayaking, swimming and scuba diving. The Gulf is back, and I’m taking advantage of being fortunate enough to live here and enjoy it!


Mike Matthews, President & CEO, H&A Architects & Engineers, Richmond, VA

matthewsHow has H&A’s performance fared so far this year?

Our revenues are up over last year but we are having difficulty obtaining our historically high margins due to increased competition in one of our core markets. We are also focusing our attention on successfully integrating firms we have recently acquired.

As H&A serves primarily a range of federal clients and projects, what design issues are critical to those agencies today?

Green design, security, dependability, constructability, life-cycle cost, and primarily, cost. Most of these aren’t new. There is certainly a bigger focus on green design and we have made changes in our business to address those client needs.

In what market or service areas are you seeing promising opportunities for growth?

We are seeing the private sector work coming back to life – particularly in the planning phases. Economists typically track new construction starts. I see our industry as a leading indicator of construction starts. My current experience and anecdotal evidence in the industry leads me to believe the commercial markets are a good place to be right now. Much of the competition is gone with only the strong surviving.

What business and/or industry challenges most concern you?

Economic growth is my biggest concern. There seems to be a lot of anti-business rhetoric coming out of Washington, with increased regulations and an appetite for burdensome reporting requirements. Unfortunately, health care reform will likely have a negative impact on our employees, our firm, and our industry. Small and medium sized businesses will certainly find themselves absorbing much of the cost for the current uninsured. We will also no longer be able to differentiate health coverage for employees at various levels in the firm. I’m afraid many could lose family coverage with no way for us to compensate them for the lost benefit.

Have you had to change your style of leadership over the last few years due to the economy?

No. But we have had to constantly communicate to our employees how we are doing. While we have seen growth over the past two years and have not had a single layoff, our employees remain nervous, having seen our industry hit hard by the recession and their friends and family members losing their jobs.

What’s on your summer reading list?

If Aristotle Ran General Motors by Tom Morris and The Breakthrough Company by Keith McFarland


John Thomas, CEO, SWCA Environmental Consultants, Phoenix, AZ

thomasHow has SWCA’s performance fared so far this year?

We are on-plan for the year at the mid-point, so good performance. Our 2011 plan was not aggressive, essentially a continuation of 2010 total revenues with an increase in net and earnings.

In what market or service areas are you seeing promising opportunities for growth?

The energy sector in its various forms leads the pack for us, with oil and gas being the most robust with a lot of activity in renewable and electric transmission.

What business and/or industry challenges most concern you?

Ironically, the renewables market, particularly wind. We are seeing a sorting out of the players and projects and changes in tax and other government policies, such as rolling back of tax credits for renewables in Oregon and the California RPS requirements for in-state generation, are reducing the number of projects with some booked work being cancelled.

How does your recent acquisition of Northwest Archaeological Associates benefit SWCA?

NWAA was a good acquisition for us in a number of aspects. We have a well-developed and successful Cultural Resources practice so there is immediate connection with our ongoing programs and our managers speak their language. Their geography, Washington State, is immediately adjacent to an existing SWCA presence in Oregon, and they provide us with a platform to leverage our other services in Washington. This completes our west coast coverage, which is a goal of our strategic plan. Lastly, they are a competent and well respected firm — so we acquired good reputation and client relationships.

Have you had to change your style of leadership over the last few years due to the economy?

Not so much style as what I focus on, that being: costs, which for us is largely employees, and increased competition and price pressures. We have had to become more disciplined with our staffing decisions and more effective in our business development.

What are your plans this summer for rest and relaxation?

A bicycle tour in the Colorado Rockies in June and another bike tour in the Basque Country of northern Spain in August. Maybe not restful, but certainly exciting diversions. I don’t seem to rest much!

Reigniting Your Firm’s Growth – Mission Impossible?

In our discussions with A/E and environmental consulting Presidents and Principals across a variety of disciplines and sizes, the overwhelming response to our question of “What’s your biggest organizational challenge today?” is a quick and straightforward: “Growing our firm again.”

Compare that answer to the biggest issues facing the design and construction industry just a few years ago. Back then overstressed executives declared to us, “We just can’t find enough people,” and “I’m not sure how we’re going to get all this work done.” My how times have changed.

And while recruiters we talk to say they are busier than ever trying to find those elusive “right people” for organizations short on emerging leaders. And business development professionals are networking and selling their firm’s capabilities more than ever, it still feels like proposals and projects have been coming in dispiriting fits and starts. Mega projects seem to be fewer and far between, and bankers are only now dipping their toes back into selective construction lending again. A sign of the times, state and local agencies are facing headwinds of tighter budgets and austerity measures. Competition for work is as fierce as we can recall, with larger firms chasing down smaller projects and practically every A/E and environmental firm is taking on lower margin work just so their “loyal” clients won’t think twice of using another design or consulting firm!

It was recently reported that economists believe it could take almost four more years for the construction industry to fully recover from the housing bubble and lingering recession. As a result, many A/E firms are trying to position themselves in growing, or resilient, markets (such as green building, energy, shale development, industrial, compliance, etc.) by any means necessary. Many leaders apologetically tell us their short-run growth and business planning exercise has been boiled down to one slogan: “We’re chasing the money.”

In this economic and design climate where we can’t rely on a broad based recovery (yet!) to lift the tide once again, many A/E leaders now realize that growth will come from taking market share away from others and/or penetrating new markets and clients. And more often than not, acquisitions are a faster way to accomplish that goal.
Serial buyers, as well as first time acquirers, have been stirring again. They are on the prowl for small to mid-size targets that immediately bolster their top line rather than risk the opportunity cost of patiently cold-starting offices (add to that the cold reality that many professionals can’t readily sell their houses and relocate to open a new branch office anyway). Small to mid-size firms, particularly in architecture, continue to evaluate regional mergers for scalability and survivability.

So if your organization is contemplating the M&A path to spur growth, here are some key objectives and strategies one should be mindful of in putting a successful combination together:

  1. Culture Compatibility – Buyers need to focus their energies on finding targets where the people, philosophies, and processes are a natural fit with theirs. Sometimes that comes with the historical familiarity of a regional competitor, in other cases it’s executives talking and courting multiple firms for comparison purposes. Is the culture “hard-charging and autocratic” or “collaborative and collegial?” There’s a big difference. Understand what makes a target firm unique, including why valued and repeat clients use their design services and why employees enjoy working there.
  2. Minimize Valuation – Now there’s a fine line with dealmaking in terms of getting a reputation for a “low-baller” or “tire kicker” and simply minimizing the price it takes to close the transaction. Acquisition teams often talk themselves into justifying higher price demands by the seller’s owners, thinking there are more synergies than really exist. Keep in mind M&A is ultimately a capital allocation exercise and that a favorable ROI or shorter payback period is contingent on fair market value vs. other internal investment opportunities. Utilize valuation experts to help calculate a sensible range.
  3. Match Consideration to Objectives – Buyers typically have at their disposal a range of funding mechanisms, including cash, installment notes, stock, and earnouts. Some A/E acquirers eschew using their own stock as currency, particularly if it trades at book value or some discount to fair market, potentially diluting their own shareholders. Others dislike using earnouts, or pay for performance contracts, as it can often create an “us vs. them” mindset and a disincentive to collaborating together. Be creative and flexible and make sure you are creating some form of incentives for key employees.
  4. Avoid Assumption of Liabilities – This objective might simply be unrealistic if the transaction is structured as a stock purchase; however, many small deals are structured as asset purchases. In those scenarios, the advantage lies with the buyer, as they are able to pick and choose which assets and liabilities they wish to assume, typically leaving known and unknown liabilities with the seller. In addition, it’s important to skillfully negotiate the amount and enforceability of indemnity provisions.
  5. Strive for Exclusivity – Buyers typically do not like getting into “auction-like” courtship and bidding contests with a seller and attempt to avoid that type of competition as much as possible. Many try to get around that by requesting a quick turnaround on term sheets before they expire and having binding no-shop provisions in the letter of intent.
  6. Understand the Sellers’ Motivations – It’s absolutely critical for A/E buyers to understand the real reasons why the owner(s) are selling. Is it due to a failure or breakdown with internal ownership or leadership succession? Are there health issues with the owner or are they just looking to slow down? Do they need access to deeper managerial, recruiting and financial resources to continue to grow? Can these entrepreneurial owners, many of whom have run their own firm for years, now thrive in a larger organizational context, oftentimes with more formalized procedures, policies, bureaucracy and chain of command?
  7. Harmonious Integration – The integration is where all the courtship, negotiation, planning and diligence now becomes either make or break. Preserving the value of the seller and minimizing business disruptions should be the acquirer’s primary goals. The retention of key clients, management, staff, and contracts is what it’s all about. Otherwise, why go through the exercise at all?

The path to success in an acquisition program is to have a viable pipeline of numerous target firms that meet your M&A criteria and then actively engage with them in a manageable and efficient manner. Our experienced team has led the efforts and processes of dozens of A/E and environmental M&A acquisition programs and buyside engagements over the years.

Table: Representative Transactions: March 2011 – June 2011

Acquirer Target Employees Price Key Markets
AMEC MACTEC 2,600 $280MM Environmental Planning; Assessment and Remediation; Infrastructure Engineering; Water Resources
Jacobs Majority Ownership of Consulting Eng Services (India) Ltd. 2,000 N/A Infrastructure Development; Planning; Engineering; CM
URS Apptis Holdings, Inc. 1,000 $260MM Government IT
HanmiGlobal Majority Ownership of Otak 300 $13MM Urban Design; Architecture, Planning; Engineering; Transportation; Water/Natural Resources
SAIC Patrick Energy Services (Division of Patrick Engineering) 200 N/A Power Generation; Transmission; Substations; Distribution; Renewable Energy
TRC Companies The Environmental Business Unit of RMT 200 $13.3MM Remediation and Restoration; Environmental; Health and Safety; Air Pollution Control; Solid Waste
Stantec The Caltech Group 180 N/A EPCM; Oil/Gas; Utilities
URS BP Barber 150 N/A Water/Wastewater
Terracon Nodarse & Associates 150 N/A Environmental Consulting; Geotechnical; Construction Materials Engineering and Testing
CH2M HILL Booz Allen Hamilton’s Transportation Consulting Business 150 $28.5MM Management Consulting; System Engineering; Asset Management; System Safety Consulting

At Rusk O’Brien Gido + Partners, we put our clients together with multiple, motivated and qualified targets in a coordinated manner so that they can select from the best acquisition candidates from a strategic and cultural fit perspective. We possess years of experience navigating A/E and environmental buyers and sellers through the M&A process and towards winning combinations. Please contact me with any thoughts or observations on M&A activity or if we can ever assist your organization.

Managing Conflicts of Interest when Selling Internally or Externally

2011 kicked off the next huge demographic shift in the U.S. – Baby Boomers entering retirement age (65). Over the next 19 years, according to government statistics, on average, 10,000 Americans per day will be retiring for a total of more than 69 million people. This shift is increasing ownership transition activities among architecture, engineering, and environmental consulting firms. As firms explore ways to buy out retiring shareholders, care must be given to the process of executing a transaction, whether it’s with a third party, select employees, and/or an ESOP.

Whatever approach your company takes to monetize the ownership interests of its shareholders, the board of directors and senior management acting on behalf of minority shareholders must take great care to avoid or mitigate conflicts of interest. Since most, if not all, architecture, engineering, and environmental consulting firms are owned by employees, the appearance of conflicts of interest or self-dealing can be difficult to avoid. The use of fairness opinions can reduce your risk of minority shareholder litigation.

What if over the last two years your company’s revenues decreased by 35%, profit margins are about one-third than what they were before, your work force is half of what it used to be, and your employees are anxious because their employment future, while better than last year, still remain a little uncertain. Then, one day out of the blue, a firm makes an inquiry to acquire the assets of your company. The cultures are a perfect match and the combined companies will likely create better opportunities for your services. Additionally, this acquisition will monetize the shareholders’ investment, give a more stable employment future for your remaining employees, but will lock in the losses on the recent investments made by certain shareholders. In this transaction, you have decided to take some of the cash proceeds and issue bonuses to those shareholders who are locking in their losses as this will make them feel better about the transaction. Is this fair? We will answer this question near the end of this Perspective.

In 1985, in the case of Smith v Van Gorkum, the board of directors was held personally liable for breaching their fiduciary duty of care by approving a merger – even though the premium received in the transaction was substantial. In this particular instance, the board of directors of Trans Union approved the sale of the company to Jay Pritzker, a corporate takeover specialist, at $55 per share by relying upon the opinions and the transaction process being carried out by a few senior managers – namely the CEO and CFO. In its ruling, the Court set a precedent that board members should protect themselves by obtaining a fairness opinion from a qualified, third-party valuation expert.

Fairness opinions are designed to assist directors in making reasonable business judgments that require the board to: (a) exercise due care in the process of making that decision; (b) act independently and objectively; (c) act in good faith; and (d) exercise full discretion in making their decision. Fairness opinions do not express an opinion value or even a range of values, and should not be confused with a valuation report or appraisal. A fairness opinion is an opinion as to whether a proposed transaction is fair from a financial point of view. It examines the value of the interests to be received in a transaction (cash, notes, earn-outs, employment bonuses, etc.) compared to the value of the interests given up. Fairness opinions are usually issued on behalf of either the buyer or the seller in a proposed transaction and do not make a recommendation as to whether or not to pursue the deal.

In evaluating the fairness of a transaction, appraisal experts take into account the broader concept of fairness involving potential conflicts of interest. Thus, the test for fairness requires the consideration of procedural fairness and substantive fairness.

Procedural Fairness
Procedural fairness requires that no one individual or group of individuals can use their control or management influence to direct the outcome of a transaction such that the benefits of the transaction inure to select individual(s) without regard for the rights of minority shareholder(s). Courts have ruled that fair dealing includes matters such as how the transaction is timed, initiated, structured, negotiated, and disclosed to directors as well as how the approval of the transaction is obtained from shareholders. In a transaction, questionable dealings include, but are not limited to, overreaching, hurried transaction, lack of arm’s length negotiation, fraud, and withholding of pertinent information. In some states, in a transaction that has an appearance of a conflict of interest, the burden of proof will initially rest on the party with the conflict.

Substantive Fairness
Substantive fairness considers the economics of a proposed transaction, including, but not limited to the types of economic considerations such as employment agreements, earn-outs, seller financing, retention compensation, rental agreements on seller-principal owned buildings, among other factors. Substantive fairness does not consider whether a higher price or more favorable structure could be achieved.

A subset of substantive fairness, but not always a requirement, is the issue of relative fairness. Relative fairness tests whether the different consideration to be received by different beneficiaries of transaction is also fair. Personally, I have opined on transactions in which principal shareholders received cash and stock and non-principal shareholders received cash only. At first glance, it might appear that the non-principals in such a transaction were better off as they received better liquidity and less risk in the transaction. However, you must also take into account the loss of economic benefits to the non-principal shareholders through the lack of ownership of the combined companies. In such a case the expert must evaluate the benefits of the consideration to be received by the principal shareholders through their ownership interest of the combined companies. The expert must investigate how the acquiring company values its common stock as well as the additional benefits of being a shareholder including perquisites such as company cars, unique retirement plans, and the like. Most importantly, the expert must assess the value accretion created by the combined companies. If this accretion were to only accrue to the principal shareholders, a non-principal shareholder could argue that the principals actually received greater consideration in the transaction.

As for the question of whether a company could give a bonus to certain shareholders that are locking in their losses was an actual situation of a distressed transaction in which I was an advisor. In this particular instance, the CEO shared with me how he was going to allocate the proceeds from the sale of the company’s assets. Since he was the largest shareholder, he felt that it would be beneficial to minimize the losses of those shareholders who are locking in their losses when they sell the company. I found this to be very generous of him, but very risky. This act makes the transaction not fair because in his generosity, he was taking the rightful economic value away from other minority shareholders for the benefit of those shareholders that were locking in losses.

Since fair dealing and fair price are examined as a whole, your financial expert should be informed of all material facts and circumstances of the transaction, even if the opinion does not directly address the aspect of fair dealing.