How engineering firms can enhance value through software and intellectual property

Enhanced technology will provide the tools to create more value for engineering firms.

By Neil Churman, Houston; and Andy Johnston, Charlotte, N.C. , 7 Mile Advisors June 22, 2017

The exponential growth of computing power, increasingly innovative software applications, and a relentless pursuit of streamlined project delivery has led many engineering firms from the world of T squares and slide rules to suddenly resembling Silicon Valley startups. Customers are constantly demanding better, faster, and cheaper projects. As a result, engineering firms have looked to software and intellectual property (IP) to gain a leg up. These innovations, if properly harnessed, should lead to an increase in value if one of the below paths are followed.

The first, and more traditional, route is leveraging a third-party application or internally developed IP to improve efficiency. If a firm can employ technology to do their work better-faster-cheaper, profit margins should improve. In the simplest sense, if an engineer can produce two sets of plans in the same amount of time it used to take to produce one, the firm’s profit and loss statement should benefit. This, of course, is under the assumption that the revenue generated by each project is constant, regardless of the amount of time or cost to produce them. Firms that work on a lump-sum or fixed-fee basis stand to gain the most from the improved efficiencies technology and IP can provide.

Technology is already employed in less complex service businesses to reduce manually intensive tasks, automate easily defined transactions, and facilitate reuse of similar historic solutions. At the farthest end of the technology spectrum, artificial intelligence is seeking to replace human recollection, judgment, and estimation in a scalable manner that delivers either comparable or better results derived from highly trained people. The primary advantage technology-based solutions have over human capital is scale.

Delivery methods like virtual design and construction (VDC) will soon become the new norm for projects of all sizes, so firms will need to adapt their methods and become fluent in the processes and tools necessary to compete. Tools like Revit, coupled with contract structures that enable and incentivize efficiency, can be tremendous value-creation methods for firms in the industry. Additionally, firms that can create their own proprietary software tools and applications can boost profit margins, particularly on projects that have a repetitive nature.

To illustrate this value creation, assume a strategic buyer values a target by applying a 6x multiple to their most recent earnings before interest, taxes, depreciation, and amortization (EBITDA). If the target firm is generating 10% EBITDA margins on $10 million of revenue, they would see a $6 million valuation. If that target can increase margins to 15%, all else being equal, the value climbs to $9 million. Firms that can leverage technology to reduce costs while maintaining or growing revenue can better attract investors or acquirers at a premium valuation. 

The second, and less traveled, route is to monetize a proprietary software or application externally by marketing it to other industry partners. Many firms that have developed IP have struggled to find ways to monetize it, either because they feared they’d lose the advantage it afforded them to compete for projects or because they lacked the ability to effectively market it. Assuming the former can be overcome, engineering firms should understand that a different set of competencies is needed to make the latter successful.

These firms need a dedicated staff whose only job is to build, maintain, and sell the software. They also need to have an appetite for a different business model that involves building prototypes, piloting with customers, gaining traction through sales and marketing, and then waiting for revenue to come in. There is little to no immediate value creation in a software-as-a-service (SaaS) business model, but it is incredibly scalable and can add a high-margin, recurring revenue stream to the typical project-based business model of an engineering firm. Additionally, the economics can be quite different from a typical engineering firm. A good SaaS business has gross margins of more than 90%. By comparison, most engineering firms tend to run at gross margins closer to 50%.

The takeaway is that firms that believe IP has value beyond internal use will need to think differently about their approach. Whichever path is chosen, software and IP should be more than just a way to get projects out the door. They should take advantage of the tremendous opportunity for engineers to enhance the value of their firms.

Neil Churman is a director at 7 Mile Advisors, where he advises architecture, engineering, and construction industry firms on strategy, mergers and acquisitions, and raising capital.

Andy Johnston is a founding partner of 7 Mile Advisors. The full-service investment banking firm focuses on working with providers of consulting and professional services to the buildings, infrastructure, and energy industries.