So you are interested in determining the value of your firm. Whether you're only considering an external or internal ownership transfer, it can be worthwhile to bone up on A/E industry best practices in firm valuation.

For instance, there are several commonly used valuation techniques, but each has problems when applied to professional service/design firms.

• Comparable firm valuation. Tax agencies recognize this technique, and it’s required in valuation reports for ESOPs. It assumes that the value of one firm can be determined by examining the value of a similar firm. While public companies can be compared, design firms are usually closely held and it’s difficult to obtain information about them. Comparing a private firm with a publicly-held company on the basis of price/earnings ratios, as is often done, can lead to inflated valuation.

• Multiple of book value. Design firms are not usually capital intensive. Their volume of business is usually far greater than the owner’s investment. Also, book value depends heavily on subjective factors like the owner’s personal philosophy about leverage. Finally, book value depends upon a clean book, without excess bad debt or accounts payable.

• Multiple of revenue. This valuation, based on gross revenue or gross service revenue (for example, “one times gross”), works for other professions where profit margins are usually within a narrow range. But profit margins within the design professions vary too much to make this a viable method.

• Capitalization of earnings. This method applies a capitalization rate to profits to arrive at value: a certain value is expected to be in place to deliver the level of profits at the assumed capitalization rate. Here again, profit margins in the profession vary so widely that it’s hard to devise one capitalization rate for the industry.

Another caveat about valuations: An internal transfer of ownership is a closed loop. It matters little what an outside buyer would pay, as the only money to be used for ownership transition is from profits. In determining what valuation is possible, PSMJ lends credence to historic cash flow of a given firm, which has far greater impact upon ownership transition than does full market value.

PSMJ’s valuation experts recommend combining book value and a risk-weighted multiple of adjusted earnings. Value is book value plus some multiple of earnings based on several risk factors (and the results checked against other valuation methods).

Book Value 
Accrual basis book value as it appears in financial statements may be adjusted in a valuation to determine realizable book value. Adjustments might be made for such items as the following:

• Unrecorded values. These might include survey records, extensive library materials, or proprietary software.

• Appraisal assets. The actual value of assets may differ significantly from accounting standards book value. For example, the appreciated value of real estate may differ from the depreciated purchase price value. Old accounts receivable may be worth less than their book value. Work in process has value.

• Deferred taxes. Some firms’ balance sheets carry accrued federal income tax liability associated with the difference between cash and accrual basis income. Since operations and tax planning usually eliminate corporate income tax liability, a valuation expert may eliminate this liability in determining value.

• Unrecorded liabilities. These might include, for example, the potential loss after insurance coverage on professional liability claims. To facilitate financing an ownership transition, keep out of your book value and balance sheet any assets or equity that are not related to the actual conduct of your primary business.

Annual Earnings: EBBT versus EBITDA
In valuations, PSMJ typically uses earnings before bonus and taxes (EBBT) versus earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA applies better to general industry than to ours, which rarely has interest taxes, depreciation, or amortization. 

EBBT defines earnings as profits from operations before discretionary distributions and expenses, such as incentive bonuses, ownership based bonuses and contributions to profit sharing plans. With recent volatility in the market, PSMJ typically uses a five-year weighted average so that one year’s unusually high or low earnings don’t inappropriately influence the firm’s value.

Risk Factors
PSMJ assigns a multiplier (between 1 and 4) to each of several risk factors, as follows.

• Team risk: The strength of the leadership team. Does the firm have a distributed leadership structure? An active leadership development plan? Is the team diverse, or all near retirement age? Is high turnover traceable to one individual?

• Strategy risk: What is the direction of the firm? Does it practice ongoing strategic planning? What is the quality and track record of that planning process? What is the track record of “follow-through”? Is management typically in alignment or in opposition on strategic direction?

• Product risk: Does the firm provide a commodity or niche service? What is the outlook for that niche (e.g., residential, energy)? Does the firm practice continuous product improvement and have a strong QA/QC program in place?

• Market risk: This is tied to market strength, and the degree of repeat business; has that percentage gone up or down in the last year? Is the firm dependent upon a single rainmaker? What is the size of the backlog?

• Operations risk: Does the firm have a client feedback system? A strong project management culture?Does the firm consistently miss its multipliers (a sign of a broken project management process)? What is the degree of unbilled WIP?

• Financial risk: This is a function of debt versus equity in the operation (ours not being typically a debt-laden industry). Does the firm have good banking relationships, which will carry through the transition?

• Entrepreneurial risk: Does the firm have success with branch offices? Has it grown well into new markets and niches (or is it likely to do so)? Is growth part of its strategic goals?

For 40 years, PSMJ has worked with A/E firms of all shapes and sizes. We have published a valuation survey based 100% on more than 200 actual  valuations performed by our valuation experts. Broken down by firm type, size, and other demographics, every data point that drives this survey is real and vetted. This report also contains dozens of case studies that give detailed insight into the value of the participating firms.