Creating Value in Engineering Firms

Professional engineering firms traditionally have had difficulties in transitioning their firms. When the originating generation wishes to retire, three options frequently taken are:

Sell or merge with an outside firm.

Sell to internal employees.

Close the doors.

If the plan is to sell, the eventual price is largely determined by the final buyer’s perceived value. Careful planning and time can substantially increase returns, and allow the seller to maximize the several variables that influence the price.

There are multiple methods of valuing firms, including use of multiples of book value, price-to-earnings (P/E) ratios, discounted cash flow and multiples of earnings before interest, taxes, depreciation and amortization (EBITDA).

Currently, the EBITDA method is favored; its value is another way of describing pretax cash flow, and design firms typically sell for a multiple of 1.5 to 3.0 times EBITDA plus a percentage of assets. In addition to the EBITDA, principals’ compensation (i.e., distributions) in excess of a normal compensation package should be added to cash flow. By projecting current or average of recent years EBITDA, it is possible to estimate a future firm sale price.

The first step in planning a future transaction is to take stock of the company. Among the data to measure are:

Sales trends.

Profitability.

EBITDA.

Utilization ratios.

Strengths and weakness of key people.

Once these factors are assessed, multiple scenarios can be projected, including increased profitability, expanded revenues, expansion by acquisition or hiring key people.

A case study

For example, Alpha Engineering had a gross income of $3,650,000 last year. There are two principals, both in their fifties. The firm’s EBITDA was $650,000, or 17.8 percent. The firm’s income over the last several years has been steady, but not increasing. Alpha has now won several long-term contracts and feels confident that income will dramatically increase. In addition to what the firm already knows, the principals hope to expand even more and set a goal of increasing fees to $10 million by 2007. If Alpha reaches these goals, the EBITDA will be $1,780,000 in the final year. To obtain this, Alpha will have to market more aggressively or acquire another firm, or both. The costs associated with such acquisitions or marketing campaign would put downward pressure on the EBITDA.

Alpha reviews their plan and feels the $10 million figure is not obtainable. They decide to set the 2007 goal for $7 million. Alpha also knows their profit margin of 15.3 percent of fees or 17.8 percent EBITDA is low and decides to increase profit to 20 percent of fees-or 22.6 percent EBITDA-if they can implement better cost controls. When Alpha projects $10 million in fees, the EBITDA is $1,780,000. However, with the reduced goal of $7 million and a 20-percent profit, the EBITDA is $1,582,000, or $198,000 less. Therefore, Alpha concluded that the risks associated with trying to gain an additional $3 million in fees would produce an additional 6.6 percent in EBITDA.

In addition to increasing the company’s income and net profit, the principals are preparing for their retirement. They have decided that now is the time to start making plans. Furthermore, they are aware that there are several options: selling to a third party, an employee stock-ownership plan or an internal sale.

New firm owners

The next step for Alpha’s principals is to identify key employees who should become owners in the firm. In the process, they identify two possible leaders. However, they also decide that these leaders do not have the business acumen necessary to carry the firm forward. Therefore, part of the transition plan must include recruiting a potential future owner with greater business skills. The next step for Alpha’s principals is to form a management leadership team with these key employees. In an upcoming meeting, the key employees will be told that the firm is making plans for a transition and that the principals wanted to include them.

A third member of the leadership team is hired and the two principals take a year to review each team member’s performance. The two original principals give each of the team members a 10-percent interest in the firm. There are buy/sell agreements executed, allowing the firm to repurchase the stock at a minimal rate should any of the team leave. To receive the stock, the junior members are required to pledge-for the duration of the transition period-the funds in an account that will eventually be used to buy out the senior principals. The new members are also required to agree that each member of the team will receive salaries and bonuses. Salaries and bonuses will continue being paid roughly as they have been previously, and only the senior principals will receive their salaries, bonuses and dividends, because they will not contribute to the fund.

Compensation for the two senior principals for the year 2000 totaled $500,000, and they agreed that their salaries and bonuses would remain the same until 2007. Income beyond their compensation would be used for dividends, of which 70 percent would be retained by the senior principals and thirty percent would be invested in the junior principal’s fund. According to the Table on page 15, should the plan meet its projections, that fund will grow to over $2.5 million in 2007, and be available to partially fund the junior partners’ purchases of the senior partners’ stock.

If the firm is valued at three times EBITDA or $4,746,000, the senior principals’ 70 percent of the firm would be valued at $3,322,200. The remaining $817,547 plus 70 percent of the hard assets at market value are still owned by the senior principals and can be financed.

Options open

Business results for the next seven years are likely to vary from today’s projections. The principals’ plans are also very likely to change over the course of seven years. However, what the above case demonstrates is that because senior principals have planned their retirement, they have options. They no longer need to sell to the first party with cash; but should the firm receive an attractive outside offer, that too can be considered.

Also, because the firm now has junior partners-and because personnel are an engineering firm’s main assets-the firm will appear more attractive to external purchasers. The buyer can discuss face-to-face with the junior principals their futures. Those meetings are also likely to aid in transition with the balance of the staff, should an outside sale occur.

The above case study is only an example and does not consider the legal and tax consequences. The senior principals’ attorneys and accountants should be consulted to maximize the return on a transition.

Alpha Engineering – A Case Study

2000 2001 2002 2003 2004 2005 2006 2007

Income
3,650
4,129
4,607
5,086
5,564
6,043
6,521
7,000

Profit 15.3%
558
632
705
778
851
925
998
1,071

EBITDA 17.8%
650
735
820
905
990
1,076
1,161
1,246

Goodwill at 1.5 EBITDA
975
1,102
1,230
1,358
1,486
1,613
1,741
1,869

Goodwill at 3 EBITDA
1,949
2,205
2,460
2,716
2,971
3,227
3,482
3,738

Income
3,650
4,129
4,607
5,086
5,564
6,043
6,521
7,000

Profit 20%

826
921
1,017
1,113
1,209
1,304
1,400

EDIBTDA 22.6%

933
1,041
1,149
1,258
1,366
1,474
1,582

Goodwilll at 1.5 EBITDA

1,400
1,562
1,724
1,886
2,049
2,211
2,373

Goodwill at 3 EBITDA

2,799
3,124
3,448
3,773
4,100
4,422
4,746

Dividends from EBITDA

85.2
170
255
341
426
511
596

Sr. partners 70% of dividends

59.6
119
179
239
298
358
417

Jr. partner 30% dividends

25.6
51.1
76.6
102
128
153
179

Jr. partners fund additions

25.6
76.7
180
283
410
564
742

Savings interest 6%

2
6
17
35
62
100

Total in fund

25.6
104
290
590
1,036
1,662
2,505

Note: all figures in 1,000’s

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