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Small Firm Ownership Transition


Dear Dave
I started my consulting firm in 1983. We have a talented staff and a good reputation for doing quality work. The firm bills between $750K and $1 million per year. The company has always been profitable due to strict cost controls and attention to budgets. We have no debt.
I am the sole owner and plan to retire in 2 or 3 years. Is there a rule of thumb to estimate the value of the company? My employees do not have much money to purchase the company from me. What are the options for them to finance the purchase of the company? Finally, would my company be attractive to another firm to buy? If so, how do I find them?
CC CA

Dear CC
In the absence of a significant number of publicly traded engineering firms to establish pricing, finding the value of any firm is a chore. Finding the value of smaller firms is even more challenging.

Small firms have a tendency to be built around the unique personality and relationships of the owner. When a practice is identified personally with the owner, after the owner withdraws and is gone, what residual value remains beyond the bare bones accumulation of tangible assets such as equipment, tables and chairs, and accounts receivable? The case-by-case answer depends on the degree to which the selling owner has developed and elevated the stature and presence of the next generation to enable them to maintain the firm’s momentum and financial trajectory (the firm’s intangible value) post retirement. The more that has been done to transfer the firm’s identity during the last few pre-retirement years to ensure likely ongoing success, the higher the overall value to the acquiring employees and the greater the price.

Assuming the next generation is emerging and creating its own identity with the firm’s clients and the markets within which the firm operates, one approach might be to price the firm at a multiple of one to three times annual average operating profits (defined as profits before bonuses and other discretionary distributions) over the last two to three years pre-retirement. The multiple selected (1 to 3, or possibly even higher) depends upon the degree to which ongoing success is likely to occur.

If circumstances are such that buyers and the sellers cannot arrive at a mutually satisfactory agreement on the likely future path of firm performance, the value might instead be set in a two-tier fashion by first establishing a base price to cover the tangible assets discussed above, and then creating a formula for the intangible value based on a sharing of actual future performance for the first two to three years or so post sale. This approach is sometimes referred to as an earn-out. The seller has a vested interest in ensuring the success of the buyer because a portion of what the seller will ultimately receive is based on how well the firm actually performs post sale. Most buyers find this approach more comforting when the asking price seems high to them at first blush.

As you’ve pointed out, which is also quite typical at most firms, your employees are not going to have a lot of extra money on hand with which to purchase your firm. Financing becomes a key issue. In many small firm transactions, the seller often provides the financing. The buyers sign a promissory note with the seller in exchange for the stock. The buyers make payments to the seller from the future profits of the firm. The length of these notes varies, but a range from 5 to7 years in duration is fairly common.

An alternative would be to arrange for a bank (or some other outside lender) to provide the financing. Due to the limited resources and the lack of a business track record of most buyers, financing of this nature often requires the seller to guarantee the note to the bank in the event the buyers should default during the term of the note. The advantage of outside financing to the seller is they receive the proceeds of the sale of their firm up front, in cash, enabling the seller to immediately reinvest the funds elsewhere and not have to wait to collect in future years. If the seller has properly selected and prepared the buyers, the guarantee is not that much of an issue as long as the seller realizes the potential obligation exists and keeps assets available to repay the bank obligation should things unexpectedly go bad down the road. Word to the wise—choose your buyers well.

Finding an outside buyer for your firm is not out of the question, but the personality-based nature of many small firms remains an obstacle. If you leave the day following the transaction, what of substance is the new firm left with? To overcome this, a buyer would most typically insist on the seller remaining active in the firm for a period of time long enough to enable the buyer to transfer relationships and alliances to those who will remain behind following the seller’s eventual retirement. This period could be months or even years depending on the particular situation. With two to three years remaining before your intended retirement, yesterday was the time to begin looking for an acquirer if you elect to pursue an outside sale.

A place to begin the search for an outside buyer is with firms you already know and possibly work with. If your firm has longstanding relationships as a sub-consultant to other firms, explore with those firms any interest they may have in bringing your services in house. If you are a prime working directly with owners, you may wish to look for firms who may be interested in adding your firm’s clients and services as a way for that firm to enter a new market.

Searching for a buyer amongst your direct competitors is the least attractive choice. Once word gets out (and it will courtesy of the competition) that you are seeking to sell your business and retire, keeping staff and clients, and obtaining future work can become tough to do.

Remember this—the earlier you develop and put in motion your transition plan, the more options and choices you will have available to you from which to select.

 

 
 
Wahby and Associates