AE Valuation & Ownership Transition Advisor: Volume 8 Issue 2

valuation 101

Ownership Transition Rookie Errors: Avoid Mistakes That Will Haunt You for Decades

Architects and engineers love a good design problem. So, when bringing in new owners, you might be tempted to come up with your own creative solution for how to do it. Every firm is unique, right? But that can be a costly decision in the long run. There’s room for creativity to be sure, but making fundamental ownership transition mistakes when your AE firm is small can create large problems as your company—and its value—grows.

AE firms initiating their first ownership transitions need to avoid the following rookie errors:

Rookie Error #1: A Non-Standard Valuation Approach

You should value your firm first and foremost on its earnings potential. Too many small firms use approaches such as book value or even more arbitrary approaches like a buyer’s ability to pay. Such approaches can hamstring you down the line because:

1. They can be unrelated to the true value of the business, and may even create perverse incentives to goose the short-term stock price at the expense of long-term value
2. Future buyers may demand the same unfair and off-market deal when the numbers are much larger
3. They make an acquisitive growth strategy all but impossible: Even strategically beneficial acquisitions could destroy shareholder value because the valuation method produces a much lower value than the fair market purchase price.

Rookie Error #2: Not Enough Ownership Distributions

Who wants to buy stock if they don’t see the value? Ownership distributions are the tangible benefit owners receive from their stock. If profitable firms don’t pay those distributions, why would a buyer want to make a sacrifice to own stock?

Moreover, profitable AE firms that mainly pay out bonuses instead of distributions create confusion over how much compensation stockholders receive for being owners vs. executives. In turn, that makes it hard to accurately determine firm value, convince the next generation of firm employees to become owners, and finance ownership transitions as companies grow.

Rookie Error #3: Off-Market Owner Compensation

When owners take salaries that are either abnormally high or low, it also confuses ownership payouts with executive compensation. For example, if owners whose annual salary should be $300,000 instead pay themselves $600,000, the company looks less profitable and, therefore, less valuable. Worse, new shareholders may feel entitled to big raises that are out of step with their actual level of ownership. And retiring owners may be reluctant to leave because too much value resides in their salary (which they aren’t paid out for when they leave) instead of the stock (which they are). Finally, excessive shareholder salaries and bonuses can also complicate a future firm sale because sellers (especially minority owners) can struggle to fit into buyers’ compensation structures and may have to endure pay cuts to make the deal work. 

On the flip side, if owner salaries are too low, new shareholders might not get enough of a pay bump to make the added responsibility worth their while.  

Rookie Error #4: Not Enough Skin in the Game

Small AE firms can be tempted to provide new owners with bonuses to cover the cost of stock purchases, sometimes so much so that new stock buyers incur no out-of-pocket expenses—and no risk.  

For example, suppose you decide to sell 2% of your $2 million firm to an up-and-comer for $40,000. That’s a lot for a 30-something engineer, so you give her a bonus ($30K before taxes, $20K after) to help her afford it and limit her out-of-pocket expense to $20,000. Sounds manageable, right? And a reasonable bonus for all she’s done to earn the opportunity?

But fast forward 10 years: You’ve grown your 20-person firm to 100 people; it’s now worth $15 million; and it’s time to expand the ownership group. The next-generation owners are again mid-level engineers who can’t afford more than $20,000 out of pocket, but now 2% of the company is worth $300,000! The prospective new owners say: “If Sally’s buy-in was only $20K, mine should be too.” But to make that work, instead of a $30K pre-tax bonus now you have to give a $500K pre-tax bonus! Game over. So, while you probably will offer financing to make ownership more affordable, you need to do so in a way that scales with the firm.