Buying and Selling the Design Practice

Editor's Note: For more about mergers and acquisitions, see "Good Catch," p. 30.Whether to diversify their areas of practice or to expand into new geographic markets, engineering firms are acquiring other design firms with increasing frequency.Buyers frequently look to acquire an established firm to avoid the time and expense of setting up a new office.

By Bruce H. Schoumacher, Querrey & Harrow, Ltd., Chicago November 1, 2001

Whether to diversify their areas of practice or to expand into new geographic markets, engineering firms are acquiring other design firms with increasing frequency.

Buyers frequently look to acquire an established firm to avoid the time and expense of setting up a new office. A buyer who wants to expand geographically looks for a firm with strong market position, often intending to retain the seller’s existing staff.

Sellers, on the other hand, are usually motivated by concerns about retirement funding and estate planning. After all, it is easier to distribute liquid assets among heirs than to allocate shares, and buyers will pay a premium to avoid negotiating with several minority shareholders—e.g. the seller’s children—to acquire control of the firm.

Once a prospective buyer and seller enter into discussion, the first step is to consult with lawyers, accountants, tax advisors and insurance brokers in order to determine the desirable legal structure for the acquisition. Taxes, liabilities and state licensing laws are all critical factors weighing on whether the buyer decides to purchase the stock of an ongoing business entity or just acquire its assets.

What’s selling?

Buyer and seller may be doing business in any of a number of arrangements: sole proprietorship, partnership, general business corporation, professional corporation or limited liability company. Different rules may apply for different types of business entities, but they all have some common issues.

When a buyer acquires a sole proprietorship, the buyer is purchasing the assets of the business. During negotiations the parties generally should allocate price among the various assets. The Internal Revenue Code dictates that the purchase price of these assets should be according to their fair market value.

For example, if the seller owns a building that the buyer will receive as part of the acquisition, the building’s fair market value should be determined by appraisal. And there might be tax ramifications. If the fair market value of the building is greater than its cost basis—the original cost plus capital improvements and certain expenses, less depreciation—then the seller may have to pay income taxes on the difference. If property has been held for more than one year, the seller will be taxed at the lower capital gains rate. The buyer then places the building on its accounting records at its market value and calculates the depreciation deduction based on market value at the date of acquisition.

If the buyer pays more for the practice than the aggregate value of the tangible assets, the difference is allocated as goodwill under the Internal Revenue Code. Unfortunately, the buyer cannot depreciate goodwill.

Taxes, Liability and Licensing

Acquiring a partnership again leads to the problem of allocating the purchase price among the assets. The sale can have significant and complex tax ramifications for the seller, including questions of depreciation recapture and whether certain payments received by the seller will be treated as ordinary income or as a capital gain. Obviously, both buyer and seller want to minimize their own taxes, which will affect the details of the sale. For example, it may be advantageous for the seller to dispose of the business on an installment basis.

When the seller is a corporation, the buyer must decide either to purchase the seller’s stock shares or to acquire the assets, but not the liabilities. Even though a share purchase is usually more efficient, such an acquisition can have unfavorable tax consequences for the buyer.

If the buyer plans to make the acquired corporation a subsidiary, the acquisition continues as an ongoing entity and usually receives the same tax treatment as before. If, however, the buyer decides to merge the acquired business into its corporation, then there are tax consequences. The purchaser may desire to acquire only the assets of the business and not the corporation itself. If the seller has substantial physical assets—such as a building—that have appreciated in value, the purchaser may want to take advantage of increased depreciation by placing on its books the value of the building at the time of purchase.

The liabilities—or contingent liabilities—of the seller can also affect, and may determine, the form of the acquisition. For example, if the seller faces a professional liability claim, or may face such claims in the future, for work done prior to the sale of its business, the buyer obviously does not want to be responsible for those liabilities. Given the circumstances, the buyer will not want to acquire the ongoing business entity, but rather will only want to buy the assets without assuming any liabilities. However, a buyer may be willing to assume certain liabilities that arise in the course of business, such as rent due on leases.

When investigating the desirability of a possible acquisition, the buyer usually determines whether there are existing, pending or potential claims against the seller’s business. The buyer will want to design an acquisition strategy that reduces the chance of inheriting such claims. If the seller is a corporation, the buyer does not want to buy the seller’s shares, because the buyer would be acquiring both the assets and the liabilities of the seller. Buyers usually prefer to purchase the seller’s assets and assume only specifically-identified liabilities.

Since most, if not all, professional liability policies are issued on a “claims-made” basis, the seller should be insured for malpractice claims made before the sale of the business. However, the seller is not necessarily covered for claims made after the expiration of its professional liability policy. Under such circumstances, the seller will either have to maintain its professional liability policy after sale of the assets, until the applicable statute of limitations expires, or make other arrangements to insure this exposure. Frequently, insurers will provide sellers with “tail” coverage, where the seller pays a premium basically to continue a policy for a stated number of years on future claims arising from services rendered before the sale.

The buyer also must consider applicable state licensing laws. If the buyer is acquiring a practice in another state, it must determine if, and under what circumstances, it can practice in the other state.

Some states require that if a corporation practices engineering, then the shareholders, or a certain percentage of the corporation’s shareholders, or even its board of directors, must be licensed engineers in the state. Some states allow professional corporations, but not general business corporations, to practice engineering.

Setting the price

During negotiations, the seller’s price must be established and the method of payment must be determined. Once again, taxes can affect not only the selling price but also the method of payment.

At some point in negotiations, the buyer will undertake an investigation of the seller’s business pursuant to a confidentiality agreement with the seller. The investigation will not only include review of financial statements and tax returns, but it should also include a review of employment agreements, existing claims and litigation, real estate, accounts receivable and other assets, permits and licenses, employee benefits and current contracts for services as well as limitations on their assignability.

After the confidentiality agreement has been signed, it is not unusual for the parties to agree to a letter of intent (LOI) that outlines the major commercial terms: price, how it is payable, what assets and liabilities are included, whether the sale is contingent upon the buyer’s ability to obtain financing and a commitment to draft the definitive agreement within 45 to 60 days. Most LOIs expressly provide that the only legally binding obligations are:

  • The seller will not negotiate with others for a defined period.

  • Each party will hold all information confidential.

  • The seller will continue to conduct the business in the normal course.

  • The definitive agreement sets forth all details of the agreement and supersede all prior agreements.

Finally, the buyer may want the seller’s principals to continue working for a period of time to assist in the transition and to maintain a continuing relationship with clients. Under these circumstances, the seller’s principals, usually enter into written employment contracts with the buyer, agreeing to work for the buyer for a specific number of years at a stated salary.

In addition, the employment contract or purchase agreement may contain a provision that the seller and its principals will not compete with the buyer’s business for a specific number of years.

Employment contracts also have tax issues that should be considered by the buyer, seller and their tax advisors during the negotiation stage.

These are just a few of the factors which should be considered by the buyer and seller in acquisition and sale of a design practice. Many more will need to be determined and discussed with lawyers, accountants, tax advisers and insurance brokers.

Streamlining Specifications

Many problems result from ambiguities and contradictions in specifications and drawings, often because designs are not understood by field and shop personnel.

Engineers who have, in the past, worked as end users of construction documents are in a position to suggest how engineers can take a closer look at their specifications so that confusion, if not eliminated, can be greatly reduced.

The mechanical engineering department at Goodkind & O’Dea Inc., Carlisle, Pa., has developed a method of streamlining certain specification sections so that field personnel can find the information they need.

They have adapted their method to a number of CSI Division 15 sections. For example, the air devices section, “Grilles, Registers, and Diffusers,” is vitally important to the entire HVAC specification section.

Goodkind & O’Dea’s air-devices specification is currently only about three or four pages long and contains three subsections: general information, products manufacturer information and an execution subsection. There are no schedules in this specification section. The products manufacturer subsection contains a few general pieces of product information along with a reference to the schedule sheets and HVAC drawings. Design professionals provide all necessary engineering data for the air devices in a schedule located on one of the HVAC drawings—typically on a sheet titled “Schedules & Notes”—located near the front of the mechanical drawing set. The air-device schedule usually contains the following information: device number, CFM rating, type of device, associated type of system, material, finish and remarks (referencing make and model number).

It is carefully noted in the specifications that the contractor may select any manufacturer, but a device must meet the minimum performance criteria and approval of client and architect, or it will be rejected.

In addition, the engineers use typical air-device scheduling notes on the drawings and use supply- and return-flow arrows to indicate the pattern designated for each device. If a device must have a specific mounting height or other criteria, it is noted directly on the drawings as well. However, if an air device is to have a typical configuration or feature—such as all air devices having integral screwdriver set volume dampers—it is noted on the schedule.