When owners of architecture and engineering firms begin thinking about a sale, one question usually rises quickly to the top: “What multiple are firms like mine getting?” It is an understandable question. It is also frequently the wrong place to start. A 7.0x multiple sounds better than 6.0x. An 8.0x multiple sounds better still. But the multiple is only half of the valuation equation. The more important, and often more difficult, question is what earnings the buyer is willing to multiply. In an active AEC M&A market, understanding that distinction can mean the difference between an owner’s valuation expectations and the value buyers are actually prepared to support.
EBITDA Is Not Just a Number
At its simplest, enterprise value is often expressed as: Enterprise Value = EBITDA × Valuation Multiple. That equation looks straightforward. The difficult part is determining which EBITDA belongs in it. Suppose an A/E firm generated EBITDA of $2.5 million three years ago, $3.0 million two years ago, and $3.5 million last year. Then, during the most recent twelve months, EBITDA declines to $2.0 million. What is the firm’s EBITDA? There is no purely mathematical answer. The seller may reasonably point to the firm’s historical performance and argue that the latest year is an anomaly. The buyer may just as reasonably ask whether $2.0 million represents the firm’s new earnings level. Neither party resolves that disagreement by debating the multiple. They resolve it by understanding the business.
Buyers Are Really Purchasing Future Earnings
Historical financial statements are essential to valuation, but buyers cannot purchase yesterday’s EBITDA. They are purchasing the expectation of future cash flow. That is why sophisticated buyers spend so much time testing the quality and sustainability of a seller’s earnings. They want to understand not merely what the firm earned, but why it earned it, and whether those conditions will continue after closing.
- For an AEC firm, that analysis can include questions such as: Is the recent decline or increase in earnings temporary or structural?
- Has utilization changed?
- Have labor costs risen faster than billing rates?
- Has project mix changed?
- Are margins concentrated in a handful of unusually profitable projects?
- Is backlog converting into revenue at historical margins?
- Have key clients reduced spending?
- Is revenue dependent on one principal’s relationships?
- Are current staffing levels appropriate for the firm’s expected workload?
- Are reported earnings supported by healthy billing and cash collection?
These questions turn an accounting number into an assessment of earnings power. And earnings power is what ultimately drives value.
The Trap of the “Adjusted EBITDA” Spreadsheet
Most sellers encounter adjusted EBITDA during an M&A process. Some adjustments are entirely appropriate. Owner compensation above or below market, unusual professional fees, one-time litigation expenses, discontinued initiatives, or clearly nonrecurring costs may reasonably be normalized. But adjustments require discipline. A seller cannot simply label every unfavorable expense “nonrecurring” while treating every favorable revenue event as permanent. A useful test is simple: Would a buyer reasonably expect this revenue or expense to exist under normal ownership after the transaction? If the answer is yes, it probably belongs in normalized earnings. If the answer is no, an adjustment may be appropriate, but the seller should be prepared to document and defend it. The strongest adjustments are supported by evidence, not optimism.
A Declining Year Does Not Necessarily Define the Business
This distinction becomes especially important when recent performance deteriorates. Imagine a historically strong firm experiencing a difficult twelve months because two major projects were delayed, several positions were intentionally carried in anticipation of new work, and an important contract award slipped into the following year. That is very different from a firm whose earnings declined because it lost a major client, faces persistent pricing pressure, or has experienced a permanent deterioration in utilization. The income statements might look similar. The valuation implications are not. This is why buyers often examine multiple periods—historical results, the latest twelve months, current-year performance, budgets, backlog, pipeline and management’s forecast—rather than relying mechanically on a single year’s EBITDA. The objective is not to find the highest number or the lowest number. It is to identify the most defensible estimate of sustainable earnings.
Backlog Helps Tell the Story—but It Does Not Finish It
AEC owners naturally point to backlog when defending future performance. Backlog matters because it can provide evidence of future revenue visibility. But a dollar of backlog is not necessarily a dollar of value. Buyers will want to understand what sits underneath the headline number. How much is contracted and funded? How quickly will it convert? What margins are embedded in the work? Does the firm have the people to deliver it? How concentrated is it by client or project? How much represents master-service agreements or indefinite-delivery contracts rather than committed assignments? Most importantly, does the backlog support management’s earnings forecast? A strong backlog can provide compelling evidence that a recent downturn is temporary. A weak-quality backlog can do the opposite. With enough evidence of a recovery, these different perspectives are fairly resolved with an earnout to bridge valuation expectations.
Working Capital Can Validate, or Challenge, the Earnings Story
There is another piece of the valuation discussion that receives less attention than EBITDA multiples: cash conversion. A firm reporting strong earnings while receivables and unbilled work continually expand will attract questions. Buyers may examine days sales outstanding, WIP aging, write-offs, billing practices and the relationship between reported earnings and operating cash flow. That does not mean an AEC firm needs perfect working capital metrics to sell successfully. Project timing creates legitimate fluctuations. But unexplained deterioration can undermine confidence in reported earnings. A buyer ultimately wants confidence that EBITDA converts into cash.
The Multiple and EBITDA Are Connected
Owners sometimes think of the valuation multiple and EBITDA as independent variables. They aren’t. The same risks that cause a buyer to question sustainable EBITDA can also affect the multiple the buyer is willing to pay. Consider two firms producing the same reported EBITDA. One has diversified clients, strong second-generation leadership, consistent margins, high-quality backlog, disciplined working capital management and limited dependence on its founders. The other has volatile margins, concentrated clients, weak financial reporting and a founder responsible for most business development. The market is unlikely to view those earnings as equally valuable. This creates an important principle for owners: The best way to improve your valuation is not necessarily to negotiate harder for another half-turn of EBITDA. It is to make your EBITDA more valuable.
Build the Earnings Story Before Going to Market
For owners contemplating a transaction in the next several years, valuation preparation should begin well before buyers enter the conference room. That means developing a clear understanding of:
- Historical earnings. Know what drove changes in revenue, margins and profitability over several years.
- Normalized earnings. Identify legitimate adjustments and maintain documentation supporting them.
- Forward earnings. Build a credible forecast tied to staffing, backlog, pipeline and realistic operating assumptions.
- Cash conversion. Understand whether earnings are converting into cash and address persistent working capital issues.
- Earnings risk. Identify customer concentration, key-person dependencies, project exposure and other factors a buyer is likely to scrutinize.
- Management reporting. Produce financial information that allows an outside party to understand the business without relying on the owner to explain every variance.
These steps do more than prepare a firm for due diligence. They improve the business.
The Question Owners Should Be Asking
The question “What multiple can I get?” will always be part of an M&A conversation. But a better question comes first: “What level of earnings can a buyer confidently underwrite?” Answer that question convincingly, and the discussion about multiples becomes much more productive. Because in M&A, the highest theoretical multiple does not determine what your firm is worth. The quality, durability and transferability of the earnings underneath it do.
Are you ready? Bring PSMJ’s 52 years of strategic knowledge to bear in sharpening your goals whether it’s to define your business strategy, execute an M&A transaction with professional transaction advisors, or establish a succession plan to ensure the firm survives for decades more, PSMJ is ready to help your firm achieve more. Click here to start that conversation.
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.