Determining fair value is complex and may use a variety of approaches. Experienced professionals can help you understand the process.
Whether you are getting ready to retire and sell your interest, or you are a professional buying in as a new owner, determining the value of an architecture and engineering (AE) firm can be clear as mud. Determining the value is not an exact science because no two design firms are identical.
Three approaches to valuation
Several approaches can be used to determine fair value. A market-based approach looks at transactions of similar firms. This approach is analogous to when you buy a house and look at comparable houses in the neighborhood.
An income-based approach uses the present value of future cash flows. This approach is only as good as the cash flow projections provided to the valuation professional.
The third approach, which is almost never used in the AE environment, is an asset-based approach, which values the significant assets held by an entity. Each value is then adjusted up or down based on factors like future earnings potential and backlog, capabilities of the management team, client concentration, market sector, and the strength of the balance sheet.
In an AE firm, the real value is generally not the assets owned by the entity but the ability of the owners to generate future cash flow.
Quick and dirty rules: book value and EBITDA
Several basic rules are also commonly used in the AE industry to help owners and potential owners determine if the fair value is reasonable.
One of the most common formulas is 1.5 times book value. Book value is the sum of the capital invested by the shareholders and earnings retained and reinvested over time. However, firms can have very different book values depending on the method of accounting they use. All parties involved in the transaction must understand if the books are maintained on an accrual or cash basis and how long-term contracts are accounted for.
Another way of getting a rough estimate of fair value is using three to four times EBIDTA (earnings before interest, depreciation, taxes, and amortization). Similar to book value, EBITDA is influenced by the method of accounting a firm uses. Using historical earnings to predict future earnings requires all parties to understand the influencing factors. Is there a large profit-sharing contribution? What types of benefits are provided to employees? Was there a significant contract with profitability that was outside of the norm?
Less common methods of getting a general idea of fair value include using 40 to 50 percent of net service revenue, 30 to 40 percent of gross services revenue, or multiplying $60,000 – $70,000 by the number of full-time equivalent employees of the company. These measures assume a certain level of profitability and growth. Two firms with very similar gross or net revenue can have very different profitability. A firm with atypical performance in one year will need to normalize its results in order to make these rules of thumb relevant.
Buyers and sellers often have a number in their head that may not be realistic based on market conditions. These methods can be used as a gut check, but they should be used with caution because there are many factors that influence price that are outside these simple calculations.
External and internal buyers
An external buyer will perform extensive due diligence before a transaction is finalized. The seller should be prepared to disclose the last three years of financial statements and tax returns; the detail of material contracts in place with employees, customers, vendors, and lessors; customer concentrations; backlog evidenced by signed contracts; as well as the corporate culture, and how the entity will be a strategic fit for the buyer.
In an internal sale, the buyer may be a current employee or partner in the firm. A formal succession plan should be developed to guide the transition. The new owners should be privy to the inner workings of the entity and be given the opportunity to step into the formal leadership role, take over customer relations, and begin to impact the firm’s growth and culture.
Price isn’t everything
Price is not the only factor to consider when buying or selling a design firm. The terms and conditions of the agreement can have significant influence on whether “it is a good deal” — which will ultimately be determined by a willing buyer and a willing seller. In an AE firm, the real value is generally not the assets owned by the entity but the ability of the owners to generate future cash flow. Experience and expertise, reputation, and client relationships play a major role in the new owner’s ability to grow and ultimately be profitable.
How we can help
Whether you are the buyer or the seller, a transaction involves a many complex decisions. It is beneficial to have a team working by your side that understands the financial and legal details of the transaction. CLA professionals can assist you in valuing businesses, intangible assets, and financial instruments such as options and alternative classes of equity. We can also help you understand the transaction process and how valuation can support and enhance your business strategy decisions.