PSMJ has long grouped the A/E industry into two kinds of firms; those that reinvest their earnings back into the firm to fuel growth, and those that endeavor to distribute as much profit as possible each year to the shareholders, and in doing so avoid corporate taxes. We call the first group the “share appreciation” club and the second the “earnings club.”
It is relatively straight forward to sell your company to a larger A/E firm if you follow the share-appreciation model. Your firm has probably grown over the years and ownership is more distributed, so a formal system of governance has been created. Your balance sheet probably shows a substantial amount of equity, and the shareholders have reconciled themselves to the fact that all for-profit corporations pay taxes.
All of these conditions, for various reasons, make an M&A transaction easier to achieve. But what about the firms that follow the earnings club model? They are much more numerous in the A/E industry, and can be just as strategically attractive to buyers.
The issue is that the very practices that place a firm in the earnings club also support and encourage continued independent operation. By definition, the shareholders of these firms maximize their earnings each year, and because profits are, to a large part, distributed along ownership lines, the impact of dilution is felt directly by existing owners. This keeps the shareholder group small and the firm closely controlled by an informal decision making process.
Making sure the annual distributions are large enough to eliminate corporate taxes also gets a lot of attention in these firms. So, what can be done if you’ve happily been operating an earnings club for 20+ years but the lack of leadership transition is pointing you towards an outside sale?
You must come to term with these things:
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Realize that each year as you maximized your earnings, you were taking out some of the value of the firm, and you won’t get paid twice for it. Reinvestment of profits is, to a company, as good as food is to yourbody. Without it over long periods of time, you undercut the health (and value) of your firm.
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Understand the value of a formal governance structure. There is no way to have an efficient decision-making process if the key managers in your firm also make up the shareholders and board members.
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Be aware that not all shareholders have to be capable of management at the corporate level. As ownership broadens in the share appreciation model, leaders within different parts of firms are commonly offered ownership. It’s possible for you to have a place on the board of directors and own fewer shares than someone who doesn’t.
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Recognize the difference between tax management and tax avoidance. Nobody likes to pay taxes, but few earnings clubs pay attention to the collateral damage of tax avoidance. Giving a non-performing shareholder a sizable distribution and saying, “At least we didn’t have to pay corporate taxes on that money,” is a backward priority system and will get fixed as part of the sale of your firm.
About the Author: Brad Wilson joined PSMJ as a consultant in 2002 as one of the senior M&A consultants. Brad regularly facilitates PSMJ’s CEO Roundtables on Mergers & Acquisitions. Every ounce of our A/E/C Mergers & Acquisitions Roundtable is driven by proven experience and the latest strategies for structuring win-win transactions… from finding the right fit all the way through to implementing a successful integration strategy.
