Dear Insider,
Do you know the value of your engineering, architecture, environmental, or construction company? Do you know how to find it? How do you set a fair share price for employees? How do you know if an offer from an outside buyer is a fair bid? Today we will give you a high-level look at the different kinds of valuations and what they offer.
Previously, we have shared the story of the ‘dilemma of success’. Many owners have had to navigate the troublesome waters of outperforming the purchasing power of their internal buyers. Just last week we shared a webinar focused on this topic [as well]. On Demand Webinar: Should You Buy? Or Should You Sell? We have since received many questions submitted from the webinar prompting us to dive a little deeper into this topic today. How do you determine the difference in fair market valuation sold to employees, vs. out on the open market?
What Makes a Good Valuation for Your Firm?
First- a look at the difference between the two:
Internal vs. External: Where the Values Diverge
You’ll notice right away that at certain sizes of adjusted EBITDA, the external model quickly outpaces the internal valuation. Conversely, at lower levels, the internal valuation beats the external valuation. So, which of these is right for you? If your firm has surpassed one million in adjusted EBITDA, chances are, you will start to see this divergence.
Start With Your Exit Goals
This question begins with your goals for an exit, if you want to find an external buyer, or a partner for growth to take your team to the next level, they are out there. If you want to sell internally, you will need to know who your internal buyers are and would these leaders make good owners. In either case, you’ll need a clear picture of what the value of your firm is.
Not All Valuations Are Created Equal
It’s critical to understand that for AEC firms, there truly is no ‘one-size fits all’ when it comes to valuation. Each firm has subtle nuances that can mean significant differences in the total valuation of a company. These risk adjustments and variables require a valuator who has an expert understanding of our industry and with it, knowledge of what is a risk to a business in the AEC world, and what isn’t. A local accountant or generalist who values a variety of industries does not have an in-depth knowledge of the AEC industry. Armed with industry specific knowledge, the right valuators can assign a clear and consistent impact to both your firm’s internal and external value.
Valuing the Internal Buyer's Contribution
The most common adjustment we see is the one made in consideration of an internal buyer. How do you account for the contribution that an employee makes when considering what price to offer them as they look to buy shares?
For large public companies, this is often a moot point, the contribution of any one shareholder is mitigated by the size of the system they contribute to. For mid-level and smaller firms this contribution is more significant and needs to be factored into a discount of goodwill towards the employee. How does this kind of ‘internal’ valuation compare to an external transaction?
We generally see that internal valuations apply a discount of 20-60% off an external value. A wide range that can be explained by the dilemma of success. Successful firms are a somewhat scarce item and valuable to buyers who have much larger sources of capital to draw on than a team of employees at a company. The simplest laws of economics indicate that a supply limited, highly demanded item paired with buyers who can meet price requirements, will result in the cost of that item going up significantly.
Conversely, the same firm is (hopefully) the only firm where its employees work and are being considered for partnership. For internal sellers, these internal buyers are the only pool of buyers being considered. This inverts the economics of the external transaction, with a limited pool of buyers facing a valuable commodity. The differences in expected value between internal and external buyers can be very significant.
How External Value Is Determined
How then is value determined on an external basis? What could you expect out of a fair market transaction? The market sets the price. PSMJ gets a picture of what the market would set from comparable transactions that we translate into multiples of EBITDA. Enterprise value in these scenarios translates to purchase price. These values are laid out on a given curve and that curve encompasses what buyers are willing to pay in a competitive process. It takes exposure to a lot of deals to understand what a fair price is. Veteran buyers have a good read on what fair price is and how to navigate the fairway on it. That price is almost always set on a multiple of EBITDA.
A Third Path: A Market Pegged Internal Valuation
An interesting approach we have seen recently is that of several large firms overcoming the dilemma of success by adjusting their valuation approach to an entirely unique structure that discounts an external value. The key to the success of this approach harkens back to the discussion around goals and the technique of valuation. These owners are committed to fair value; balancing the possibility of selling externally with choosing to maintain internal ownership. Just like the other approaches, this valuation approach identifies a fair price based on the seller’s goals and chosen market.
Getting the Transaction Right
Whether you are considering selling shares in the next few days, or this kind of transaction is a distant goal over the horizon, we hope you’ll do it right. It’s important to remember that the true price of a transaction is whatever amount a willing buyer is willing to pay a willing seller. On the external market, you’ll see a very wide variety of offers for a given seller, and even the most veteran buyers can (and very often do) miss the mark on a deal they set their sights on. The right M&A advisor will help a buyer dial their offer on a competitive deal to help them land a winning transaction, just as much as they’ll steward the seller’s journey of discovery in the search for the best fit of culture and price.
On the internal side, the best transactions are valued correctly and fairly, with a clear picture of how to structure the sale of stock to ease the burden of their cost for internal buyers, often selling shares down over an extended period to a larger pool of individuals. Critically, any internal transition requires a look towards the next generation after the current inbound one, and considerations should be made to ensure a framework of development is maintained for future leaders.
A Note on ESOPS
The last option for exit many owners consider is setting up an ESOP which entails a different valuation methodology. PSMJ has expertise in providing these valuations as well. But that discussion is for another edition.
PSMJ has advised AEC firm owners through both buy-side and sell-side transactions across the full range of deal structures, including strategic sales, mergers, private equity recapitalizations, as well as internal successions. Our M&A advisory practice is built on proprietary financial benchmarking data drawn from hundreds of AEC firms, giving our clients the analytical foundation to understand where their firm stands, what it is worth, and which strategic path is right for them. If you are beginning to think seriously about your firm's options, we welcome the conversation. If you'd like to learn more, find out here.
This article is intended for informational purposes and does not constitute legal, financial, or investment advice. Firms considering intellectual property strategy or M&A transactions should consult qualified legal advisors.