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2019 Perspectives

Want to Increase Value for your Firm? Pull these Levers!

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:

  • Bullpen – make sure you have a list of people you can hire if the need arises. Identify who they are, where they are, and how you can get them. This list should always be current.
  • Marketing – too often, firms market only when they need the work. This practice, however, just replaces the completed work and often results in a “sawtooth” picture of revenue where one period looks great and the next not so good.
  • Project Management Capacity – growth has put more firms out of business than lack of work. Why? Because, often, the existing management structure is incapable of managing the increased workload. As a result, the risk of mistakes increases, profitability and quality of work suffer, and invoices go uncollected. Confirm you have the systems, processes, and people that can handle increased business without sacrificing quality and profitability.
  • Credit Capacity – growth sucks up cash. Make sure you have the funds to fuel this growth which can be existing cash, the ability to temporarily draw on a line of credit or take out a loan. And, collect your receivables promptly.

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:

  • Timely and Accurate Financial Reporting – better decisions equal better results. You can only make better decisions if you have the information to base them on. Your financial reports should provide you with the data that you need to evaluate prior to making decisions and taking corrective action. In this regard, they must be simple, concise and actionable. Furthermore, they must be accrual-based as the cash-basis format is by nature not timely nor accurate.
  • Processes for Reducing Risk and Increasing Efficiency – as an owner and leader, you should be relentlessly and mercilessly driving unnecessary risk and inefficiency out of your organization. One of the best ways to do this is by developing processes and systems that can be repeated with accuracy and simplicity and that are not dependent on certain personnel.
  • Pricing – increase your prices. There is no greater or easier way to increase profitability than by raising prices. Any increase in price drops straight to the bottom line without any additional cost associated with it. Almost every business in the world raises its prices – because costs go up, like your cost of labor. You give raises and bonuses  – so you need to pass along that increased cost to your clients or face the dreaded margin squeeze. When is the last time you raised your prices?

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:

  • Bench Strength – organizations with a team of capable leaders are more valuable than ones in which one person holds all the knowledge, client relationships, and rain-making capabilities. By being the center of power and control in their firms, owners create more risk and drive down the value of their firm by limiting the longevity of the firm to their own tenure at the helm. Whether external or internal, buyers like to know that the firm can survive the departure of the current leaders, as it takes time to recoup their investment and make a profit.
  • Diversification – in the pursuit of revenue and “that big project,” it can be quite tempting to allow revenue to concentrate in a single client or client type. However, the risk profile of such a scenario will deter most investors, and rightly so. In small companies that are just starting, it is very likely that concentrations will occur. But whether you are a new or an established firm, you should focus on growth in new clients and project types that increase your diversification and not your concentrations. A good rule of thumb is that no more than 15% of your revenue should come from a single client or client type.

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.

 

The latest trends in A/E stock valuation and M&A pricing

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.

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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.

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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.