Your questions answered: Selling in or selling out: deciding which ownership transition path to take

What’s the succession plan for your engineering firm? Nick Belitz of Morrissey Goodale responds to unanswered questions from the July 31 webcast event.

By Nick Belitz, Morrissey Goodale, Denver August 7, 2015

Nick Belitz of Morrissey Goodale responded to the many questions that were left unanswered from the July 31 webcast "Selling in or selling out: deciding which ownership transition path to take."

Question: What is the best way to complete a buy-out option?

Nick Belitz: It depends on the terms of the option itself and the restrictions and provisions assigned to both the buyer or organization and the seller. Ideally, the option will be written to protect the liquidity and solvency of the firm while still providing the selling (and presumably departing) owner the appropriate value for the shares.

Question: How is a company’s net worth established?

Belitz: It depends on what is meant by "net worth." If you mean net asset value or book value (both accounting terms), then it is a measure of the value of firm assets or the value of the owner’s equity after all accounts have been collected and paid. Neither method is the best indication of the true value of an engineering firm. The best valuation tool we have is the discounted cash flow method to assess the value of future benefit (profit) streams.

Question: We have an internal plan involving 10 years. Other than who the next generation is, there has been little structure developed with the assistance of the owner. Any thoughts on how to motivate this activity?

Belitz: Manage it like you would a project for a client. Set project milestones with a timeline in place and name specific individuals responsible for key tasks, like meeting with the bank or making sure the buy-sell agreement is in place. Then hold those individuals accountable. If you have regular meetings to check in on the status of projects, add "ownership transition" to the agenda and ask hard questions of those responsible if the initiative fails to advance.

Question: Two questions: 1. What is the best way to value firm for internal sale? 2. Describe the best way to value firm for external sale.

Belitz: The best way to value in either case is a detailed discounted cash flow model, which often requires the input of an impartial third party or valuation expert to produce, plus a substantial bit of time and thought to model in the correct assumptions about the forecast period. The key to remember as an owner is that in most cases, internal transitions take longer to complete and yield a lower dollar amount for the sellers while external sales result in a greater cultural shift, for better or worse. It’s critical to assess your specific firm’s culture and next generation leadership before committing to one or another.

Question: How do you put a selling price on one’s firm?

Belitz: Make a good profit and do it consistently! Buyers, whether internal or external, will be more comfortable with acquiring shares of an engineering firm when there is a good track record of profitability. The mechanics of doing so are more detailed and are best handled by a discounted cash flow exercise. See the answer to the above question.

Question: How to approximate the value of the company, especially given several recent years of being unprofitable during the economic downturn after more than 40 years of being profitable.

Belitz: In general, we see most buyers comfortable with relying on the more recent years as a guide for the future and letting the bad recessionary years carry less weight in the analysis. The problem is "less weight" is different than "ignoring them completely." We’ve seen plenty of firms that grew through the recession and, fair or not, you’re in competition with those firms’ warts and all. Forty years of profitability is a great thing to point to and sets the stage for a good story, but remember business, like politics, is a "what have you done for me lately" kind of world. We’re living in a different world than we were in 2000, 1990, and 1980—don’t rest on the laurels of decades past!

Question: Buy-sell agreements for internal plans.

Belitz: There is no set rule for how these agreements are written, but they should cover not only how and when shares are transacted, but what happens in the event of a forced sale or the three D’s—death, disaster, or divorce—befall of one of the partners. Some agreements include formulas on how share price is determined, but this is an area where an impartial third party—an advisor or attorney—should definitely be involved.

Question: Help explain creative financing for new junior partners to buy shares, and the timeline for share distribution.

Belitz: Shares are bought with two forms of payment: equity or debt. If the junior partners can’t afford or are unwilling to pony up their own equity, then the firm’s current owners need to consider getting a third-party loan to finance the shares or having the firm itself extend a loan to the incoming shareholders. If using equity, then firms can either give raises to the junior staff to buy shares so they don’t see a negative cash flow impact on their paychecks or plan to use bonuses to cover the cost of the stock. Timelines vary considerably, but 3-year or longer purchase plans are quite common.

Question: How do we structure an external sale so that it encourages existing employees to stay on? What are the pitfalls of ESOPs?

Belitz: External sales often turn out well for existing employees, who frequently enjoy better health insurance plans and often get base pay raises under the new regime. The structure of the deal itself is determined by the buyer and seller; the best thing to do for employees who have no control is to sell the perceived benefits of the sale to them early on. If the firm leaders are staying put after the transaction, say so early and often. The biggest concerns people tend to have revolve around keeping their jobs and keeping their doctors. Address those issues first. Thankfully, it’s easy in this industry because mergers and acquisitions among smaller, privately held firms tends to results in very few layoffs of professional staff.

Question: How do you apply a dollar value to present ownership’s good will with existing clients?

Belitz: That will be taken into account by estimating the future cash flows, which will be driven in part by client relationships. "Good will" is a separate accounting term for an item on the balance sheet that is different from the fact that a specific firm may have had the same client for decades. Sadly, it’s all about the money.

Question: How do we initiate a transition?

Belitz: That’s a tough one without knowing where in the process you are. But in general, you need to identify the staff who will lead the business when the current owners have departed. Leaders can be developed and groomed, but you need to take an honest look at where the firm’s next generation stands in terms of strengths and weaknesses.

Question: How do we prepare for a successful transition?

Belitz: Treat it like a project for a client. See the answer above.

Question: How do we sell an existing business for a fair price?

Belitz: See answers above.

Question: What are the pitfalls of S corporation, or ESOP ownership?

Belitz: I’m not sure if you mean S corporation that is a member of an ESOP or the pitfalls of each independently. ESOPs in general are great vehicles to defer taxes and distribute ownership to a wider base of employees, but they carry heavy administrative requirements and costs to comply with the law. S corporations avoid the double taxation of income by Uncle Sam, but they are limited to the number of members.

Question: What can be done to prevent a mutiny if we are selling a small firm to external buyers? Especially if senior folks don’t have ownership stake.

Belitz: Typically, ensuring that the two cultures are a match serves as a deterrent to this kind of behavior. The key is to involve the senior non-owners at the right time. If they believe ownership has been promised to them, you’re in trouble. However, we’ve had cases where senior employees that were not owners welcomed the news of the sale because it would mean more opportunities to advance. Another tactic is to build incentive plans to keep key staff in the game—the sellers may need to take a lesser deal or give the folks a small piece of the action, but it could be the difference to getting a deal done or not.

Question: What is the best plan for me to buy the business? I’m currently partial owner and do not have enough fund to buy it.

Belitz: That depends on the attitudes of the majority owners and whether you as a group are willing to take on debt from a third party to fund your share purchases. Another option is to have the company itself extend you a loan at a reasonable rate. You can use the dividends and bonuses over time to pay off the loan to the firm. The world runs on other people’s money and often it’s the only way departing shareholders will get their money out.

Question: What makes a consulting firm attractive to buyers?

Belitz: More than anything, consistent profitability. One or 2 good years won’t cut it. And remember buyers will pay more for a $2 million business that reliably generates 20% profit than a $3 million business that generates 10% profit because of greater certainly of a return on their investment.

Question: What do I look for in potential buyers?

Belitz: Can you get through a lunch with the senior leadership and not talk exclusively about projects and work? Are you able to joke about the same things and share common experiences? One of the best partnerships I’ve seen started as two guys who needed a buddy to go fly-fishing with and then realized they were both in the same business. It’s a cultural fit first and foremost and you’ll figure it out pretty quickly through a couple of meetings and business meals. After that, drill down on the financial stability of the buyer—if they don’t talk about their financial success early or have some convulsed way of rewarding owners with a deferred compensation plan that doesn’t make sense to you, take it as a red flag.