Dear Insider,

For mid-sized firms exploring acquisition strategies, being privately held can be both an advantage and a challenge. Over the past year, PSMJ has facilitated strategic planning sessions and valuation exercises with numerous active or soon-to-be-active buyers in our industry.

One recurring issue we’ve encountered is a complement to the challenge faced by sellers regarding ballooning external valuations that we’ve previously discussed HERE. Specifically, many buyers undervalue their firms for internal stock sales to such an extent that they risk diluting their value when offering stock as part of an M&A transaction.

The Dilemma of Low Internal Valuations

Financial management decisions are rarely straightforward, and this issue is no exception. A low internal valuation can make ownership more accessible for internal buyers and ensure a smooth transition for successive leadership generations. However, it also conflicts with a board’s fiduciary responsibility to shareholders, making it difficult to compare internal stock sales with external majority or minority sales to financial or strategic buyers.

This disparity becomes particularly stark during the current period of record-high industry profits, where external valuations from financial or strategic buyers often significantly exceed those based on book value or modest earnings multiples.

Potential Solutions to the Problem

Different firms address this challenge in various ways, depending on their priorities. Here are two common approaches PSMJ has observed:

1. Realigning Valuations Some firms opt to adjust their internal valuations through a customized process, aligning them more closely with fair market value. This approach enables a direct comparison between internal and external valuations, creating consistency when offering stock in acquisitions. However, this process must be handled delicately to avoid disrupting ongoing internal stock transfers.

   PSMJ’s valuation experts have been actively assisting firms with such realignments, and the results have been promising. Firms that undertake this strategy are better positioned to use stock in transactions and reduce the risk of external buyers undermining their value.

2. Avoiding Stock-Based Acquisitions Other firms choose to sidestep the issue by avoiding stock in acquisitions altogether. This strategy may help preserve an established culture of ownership and a continued practice established over multiple generations. However, not using stock puts buyers at a disadvantage because using stock preserves cash reserves and allows a seller to benefit from the ‘second bit of the apple. Despite reducing M&A options, advocates for this approach argue, it also mitigates the risk of over-cooling or otherwise destabilizing internal ownership markets and the potential creation of succession challenges.

   For these firms, the trade-off is fewer options in their acquisition opportunities but greater internal stability—as long as successive owners remain committed to this approach and do not decide to later sell to an external buyer at a far more competitive price.

Strategic Considerations for Firm Owners

For many firm owners and ownership teams, these conversations mark the first time they’ve considered how their valuation practices align with their long-term goals. At PSMJ, we encourage you to explore these issues proactively before they become urgent. With the right knowledge and planning, you can make informed decisions that support your objectives.

There is no ‘one-size fits all’ approach to valuation, so when considering your valuation, make sure ‘this-size-fits-right’ for your firm. Undervaluing your firm can fail to adequately reward current owners who have contributed to the success of the firm, while overvaluing can disrupt the delicate ecosystem of internal buyers.

Consider this balance when thinking about your firm and its valuation. The right valuation should be custom-built for your firm and updated as it evolves by a valuator with expertise in this industry- someone who knows the nuances of A/E/C firms. 

Every week, we speak with firm owners who have had to navigate the results of poorly done valuations. Our next article will dive into this issue, including what happens when a below-market valuation divides a firm’s ownership team.

Have you thought about how your firm’s valuation impacts your business strategy? Does your valuation pass the gut check and feel like the right fit for your firm? Let us know with a comment below:

*all comments are reviewed by PSMJ’s M&A advisory practice, and are not shared publicly unless you request them to be.