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2019 Perspectives

But Who’s Going to Buy ME Out? Three Paths for A/E Owners

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.

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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.

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.