The Lowdown on Buying or Selling an Engineering Firm (in Austin, Texas and Beyond) – Part 1

During the past nine months (2016-2017), I represented four sellers of engineering firms based in Austin, Texas. My role has been as their M&A attorney. In three cases, the seller sold to a much larger engineering firm. In one deal, the seller sold to a private equity group that bought a larger engineering firm a few years back and is using that first purchase as a platform for future acquisitions. It’s interesting this is quickly becoming a cottage industry for me. One owner of one of the selling firms told me the information on my site resonated with him because I approach and look at the world like an engineer. I never heard that before, although I appreciated (what I took to be) the compliment.

In this article, I lay out some things buyers and sellers of engineering firms should consider when getting into the M&A (mergers and acquisitions) game. I also provide general information about engineering firms and the industry to help other advisors – M&A lawyers, investment bankers and appraisers who are working with engineering firms in the merger and acquisition process.

Overview of the Engineering Industry in the United States

Before diving into the mechanics of the M&A process for engineering firms located in Austin, it is important to get an understanding of the industry. Those who work in or with the engineering industry know that most engineering companies are small, privately owned, professional service businesses with less than 25 employees. In fact, fewer than 8% of U.S. engineering firms that fall under SIC code 8711 and NAICS 54133 (the industry code for most engineering ventures) have more than 25 employees.

Despite their small size, these firms can generate sizeable annual revenues, with the average engineering company bringing in approximately $3.5M each year. Revenue per employee for engineering firms hovers around $211,000, but that is just an average. Your firm or the firm you want to buy may have much higher or lower revenue per employee. This depends a lot on the type of service being offered and the typical client. It also may depend on how well run the firm is. You’ll need to dig deeper to figure out exactly what a different number signals (is it strong vs. weak management or a function of the particular target activities and clients).

While the top 4 engineering firms account for about 15% of the engineering consulting industry’s $208B in annual revenue, smaller firms must distinguish themselves through several factors. Perhaps the most significant factor is their ability to be highly specialized in a specific engineering discipline or sub-discipline. Some of the broader engineering disciplines include the following:

• Electrical engineers
• Mechanical engineers
• Industrial automation engineers
• Civil engineers
• Structural engineers
• Environmental engineers
• Chemical engineering consultants
• Information technology services engineers and IT systems engineers

Most engineering consulting (NOTE: engineering firms often describe themselves as engineering consultants because much of their work is advice-related, not merely construction or implementation – there is usually a high degree of design and advice) companies providing services related to these broader disciplines are locally owned and operated. Whether they are in Austin, Houston, Dallas, San Antonio, or anywhere else in Texas (or elsewhere in the U.S. for that matter), these smaller firms tend to find their niches in their target geographies and differentiate themselves in a manner that makes them attractive to potential buyers. And being locally owned and operated is a plus given the extensive licensing requirements for the industry.

So, whether you are looking to acquire, sell or merge an existing engineering firm, a key way for determining the business value of a firm turns on how it differentiates itself from the competition. Earnings alone may not provide enough insight to properly value the business. Earnings are historical-looking, whereas strong differentiation can be forward-looking if it signals a strong market position and long-term pricing power. Ultimately, earnings are critical, although don’t overlook the fact that they may not tell everything and a firm that has taken the time to carve out a strong market position may be poised for outsized growth going forward and some of that may not yet be reflected in the earnings history. If you’re selling your engineering firm, you want to make the argument to the buyer that the future is particularly rosy based on the work you have done to-date to position the company for the future and that’s all about differentiation and competitive positioning.

The Role of Professionals in the M&A Process

When selling or acquiring an engineering firm, there are several different professionals you are likely to encounter. In the engineering industry, we hear about mergers and acquisitions of small-medium firms with large firms quite often. However, just because you might be the “little person” in a particular transaction does not mean you’ll have a bad transaction team. Instead, you want to assemble a team of professionals who will help you maximize your goals for the transaction. Each professional has a unique role in the M&A process and can be a key ally for you. What follows is a brief overview of each one of these players and the role they play in the M&A process.

Business Brokers / Investment Bankers

Business Brokers: Business brokers (also called business transfer agents or intermediaries) assist buyers and sellers in the buying and selling of their privately held small engineering firms. They generally work on transactions in the $2M and under range – for the so-called “main street”-type business. Business brokers handle a variety of tasks, which can be grouped into the following three major categories:

• Preparation for a sale
• Marketing the business
• Closing a deal

Business brokers may work for a monthly fee, although they generally provide their services in the same manner as a commercial real estate agent – on a full-service and contingent basis, whereby their full commission is earned if and when your deal closes. The broker services vary widely depending on the interests and skill set of the broker and what you hire the broker to do.

The key is finding someone who will be your ally during the course of the transaction – a broker for whom your transaction is exciting and represents a nice commission for them, but is also within their sweet spot. In other words, you don’t hire Goldman Sachs (a tier-one investment bank) to sell a $2 million company. Even if they’d do it (and don’t worry, they won’t!), they wouldn’t put much effort into it. Goldman Sachs represents $2 billion companies. A commission on a $2 million deal would not be worth much thought (nice to be them!). On the other hand, you don’t want to hire a business broker that generally sells $400K businesses if you have a $10MM company. There is a saying in the mergers and acquisitions world that small and large deals are the same, except for the number of digits to the left of the decimal point. While there is some truth to this saying, it’s not entirely right. You want professionals, including a broker, that are comfortable with companies of a certain value. The nuances of the negotiations will vary by transaction size and the parties in the deal are different in terms of style and sophistication, depending on the size of the business being sold.

Depending on the valuation of your Texas engineering consulting firm, you may need a business broker for your transaction. If the valuation is higher, then an M&A advisor or investment banker may be a better fit.

M&A Advisors and Investment Bankers: M&A advisors and investment bankers, like business brokers, are intermediaries who help you either acquire or sell a company. They typically get involved in the lower middle market (companies that sell for between $2M to $50M) and upwards from there. In addition to providing strategic advice on the M&A process, investment bankers are often involved in raising capital and selling securities. They usually have licenses to deal in securities, whereas as business brokers typically do not. So, if you plan to sell stock (equity) in your privately held engineering company, then an investment banker is probably a better fit. For reasons why you’d choose to sell stock rather than assets, read Ways to Structure Company Sales and Purchases (M&A Deal Structures).

Two great reasons for involving an investment banker or M&A advisor is to seal the deal and to maximize the terms of the deal. The sale of an engineering firm in Austin or Texas generally can sometimes be a difficult procedure for both sides of the deal, so what could be more beneficial to the entire process than having a talented, highly experienced third-party negotiator working for you to keep discussions from being too clouded by the differing perspectives of either party? Great deal makers help get deals done on terms that are good for their clients. They understand navigating emotions and preserving relationships, while also maximizing value to their client. They also shepherd the process and ensure that the transition is made as smooth and legally sound as possible.

M&A Lawyers

A critical player on your deal team will be your lawyer. The lawyer you engage will work directly for you (or your engineering company), as opposed to working as a neutral intermediary. All lawyers owe their clients fiduciary duties, which means that your lawyer will have your best interests in mind.

M&A lawyers provide a variety of services, including preparing non-disclosure agreements (NDAs) or confidentiality agreements and preparing purchase and sale agreements, seller-financing promissory notes and helping with due diligence. Employment and tax considerations also generally fall to the lawyers, although sometimes a CPA is needed.

By far, the most important consideration in choosing a lawyer is that they have plenty of knowledge and experience with mergers and acquisitions generally. It helps if they have experience in your industry – with mergers and acquisitions involving engineering firms or engineering companies. When it comes to M&A, different industries have specific nuances that only an experienced corporate attorney can help avoid or address. For the engineering industry, states have rules for licensing, corporate structures and oftentimes require specific forms. Your corporate attorney can help guide you when it comes to these nuances.

Besides having a lot of M&A experience, an important thing you should look for is a lawyer you like and who will work the way you want to work. This is your deal. The lawyer is there to help you make it happen while also keeping an eye out for and addressing issues that could undermine your deal goals. So, it is important to find a business attorney who has your back and talks language that makes sense to you. There is no one way to lawyer a business sale or acquisition. How your lawyer works (what they do) is a function of your budget, your appetite for risk and your ability to handle things in-house with internal people. These are things a strong corporate attorney will discuss with you in determining what to do and how to properly approach and budget the legal fees for your deal.

Business Appraisers

The price you can expect to receive for your engineering firm or engineering company will likely play an important role in your decision if and when to sell. However, determining a reasonable expectation regarding sale price is not a simple exercise.

What matters most is finding an objective measure of fair market value for your engineering firm. Calculating the fair market value is something you will likely want help with, so you should find a professional business appraiser to perform the calculations.

A qualified business appraiser may use any number of methods to evaluate your business – from discounted cash flow analysis to comparable company analysis to precedent transaction analysis. But you need to know that valuation is more art than science. Don’t leave money on the table by choosing financial advisors that lack deep knowledge of the engineering consulting industry. Anyone can run a database search, but true professionals will be invaluable in helping you select the right price at which to sell your Texas engineering firm or engineering company.

Note that business brokers and investment bankers will value your firm. So, it may not be necessary to hire an appraiser if you know you are going to hire a broker or banker and go down the path of selling your firm. Or, a broker or banker may provide an estimation of value as a complementary service to build a relationship. Sometimes, though, it’s simpler to engage an appraiser at the start to figure out if it makes sense to go further.

CPAs

Accountants are invaluable during the M&A process. They help bridge the gap between fair market value and financial data presented under GAAP. Accountants can help you identify tax and accounting issues, which drive many deals and can directly impact the purchase price (decisions such as whether to sell the assets of your business or the stock/equity of it are key decisions to make at the start), while also helping deal with those issues that might crop up. If a valuation assumption is wrong or if the transaction structure would take away from the price you pay or receive for the deal, your deal team’s accountant can spot those issues and try to resolve them.

Accountants can provide services vital for selling your engineering firm or engineering company, and you should certainly include at least one accountant on your deal team. When buying a company, accountants help determine the quantity and quality of earnings, the quality of assets and liabilities, conduct due diligence, handle tax matters or considerations, determine your working capital and cash flow, among other services. In sum, you will want a good accountant as part of your deal team.

Selling a privately held engineering firm in Austin, Houston or elsewhere in Texas is a significant decision, so make sure your deal team works for you. Every issue, no matter how technical or complex, can be boiled down to something you can understand and make a decision about. You want counselors and advisors around you who adapt to your needs and expectations.

Key Operating Metrics for Engineering Firms

Generally speaking, your goal as the seller of an engineering consulting company is to make your business as profitable as possible, which makes your engineering firm a ripe target for prospective buyers. Buyers prioritize profitable businesses. Whether you’re buying or selling an engineering firm, there are five key metrics that you will want to look at to gauge the performance and profitability of each engineering consulting firm’s business model. So, before jumping into the M&A process, sellers of engineering firms need to make sure that they have processes in place to collect information on these metrics and address any issues that might negatively impact profitability.

Those metrics are:

• Utilization rate
• Billing multiple
• Breakeven multiple
• Working capital
• Net Income Per Employee (NIPE)

Let’s walk through each of these metrics so you, as the buyer or seller of an engineering firm, have a good understanding of what to expect and how to evaluate each metric as part of the M&A process.

Utilization rate is the percentage of hours employees work that is charged to clients. The utilization rate measures both how busy employees are and their capacity to take on additional projects or assignments. Both buyer and seller should be looking for a target utilization rate of 65-67%, although firm principals (who spend the bulk of their time on business development) should generally have a target utilization rate of 50%. Anything below these levels means there may be problems with profitability or, in some cases, process or other flaws preventing the engineering firm from reaching optimal utilization.

Next, there is the billing multiple, which is how much the firm bills compared to its labor costs. Before the financial crisis of 2007-08, engineering consulting firms had an average billing multiple of 3.0, but certain firms may not have reached that old standard – especially those working in industries that are in down periods, such as engineering firms working with oil and gas companies in Texas, which until recently were significantly impacted by the low price of oil and natural gas.

Given that a billing multiple of 3.0 is the target, you should evaluate the billing multiple on several different levels, starting with individual projects and expanding upward to the entire firm. This gives both buyers and sellers a better understanding of how the engineering firm is doing and how it handles the workflow. Many engineering firms have a much higher multiple at the start of a long-term project, but that multiple decreases as deadlines shift and project scope creeps.

Relatedly, the breakeven multiple shows the minimum amount of money the engineering firm must make to cover its labor costs. The breakeven multiple, which should be less than 2.7, reveals the engineering consulting company’s profit when compared against the billing multiple.

Working capital shows how much liquidity the engineering firm has. Working capital is current assets (accounts receivable, cash, marketable securities and inventory (many engineering firms have little to no inventory)) minus current liabilities (accounts payable and short-term loans). When looking at working capital, you’re essentially asking if the engineering consulting company can pay its bills. Positive working capital is important, especially in the long term, but engineering firms sometimes run on thin working capital or negative working capital. In these situations, the engineering company may not have as much advantage in a merger or acquisition.

The final metric you should evaluate on a regular basis as the seller and, for buyers, during the M&A process, is the net income per employee (NIPE). NIPE is calculated by dividing the engineering firm’s net income by the number of employees. If the NIPE is high, then the engineering company is efficiently using its employees. NIPE for engineering firms hovers around $211,000.

If you are interested in selling your engineering consulting firm or merging with another company, then you will want to monitor these five key metrics over time so you can make improvements. Potential buyers are also going to want to see historical data on these five key metrics when evaluating an acquisition or merger. So, keep these key metrics for engineering firms in mind as you enter the M&A process or consider entering it as part of your exit strategy.

If you want a trusted advisor to jumpstart your new venture, call me at 512.888.9860. I am happy to discuss your plans for the engineering firm. As your business attorney, I can help you accomplish your goal of selling or buying an engineering consulting company.

Be sure and read:

The Lowdown on Buying or Selling an Engineering Firm (in Austin, Texas and Beyond) – Part 2

The Lowdown on Buying or Selling an Engineering Firm (in Austin, Texas and Beyond) – Part 3

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Author: Brett Cenkus

Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.

2020-11-30T17:10:44-06:00