What is an Engineering Firm Worth?
So, the big question: what is your engineering firm worth (or, if you are looking to acquire a business, what should you pay for it)? Luckily, valuation is something each of us does every day. Whenever you purchase a new company vehicle or acquire new software vital for your engineering company, you have valued the product and determined it was worth the price paid. When it comes to mergers and acquisitions of engineering companies or engineering firms, there is more that goes into the equation, but the core principle still holds. This is something you as an engineering company or engineering firm owner will want to know – whether you are looking to retire, trying to move on to the next big thing or just looking for a change of scenery.
Before addressing valuation in general, it is important to understand the difference between public and private companies. When you sell a share of stock in, for example, Schlumberger Ltd., Halliburton, or National Oilwell Varco on the New York Stock Exchange, there is a market for that share that determines the price. Whether that price is $15 or $100, you know what the share is valued at. In contrast, there is no NYSE or equivalent for shares of stock in privately held engineering companies or engineering firms. In a sense, there is no “market” that sets the price for each share or, in some cases, the assets of the engineering firm. So, it can be much more difficult to figure out the value for private companies.
That’s where professional business appraisers come in handy. Valuators can step in and determine that value for you based on information about your company, information about the engineering industry, and their own professional business judgment and experience. So, let’s unpack their process.
First, the most complicated aspect of valuing an engineering company in Austin, Houston or in Texas generally is determining the value of the human capital and other intangible elements. Engineering firms, generally speaking, tend to have more “human capital and other intangibles than, for example, an oilfield services company, so your bottom line valuation is going to be based in large part on your people and relationships. Beyond that, there are several other characteristics of engineering firms that should be factored into the valuation:
- The licenses held by employees at your engineering firm as well as any other professional certifications or courses of study completed;
- The trust between employees and managements as well as the owners; and
- The relatively small amount of fixed assets owned by the firm.
Second, it is important to have a good understanding of the basic standards of valuation. I have previously used the term fair market value, but what is fair market value? Well, fair market value is the most common standard of valuation. It can be defined multiple ways, but the U.S. Treasury Department defines it as follows: “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Did that clear things up? I didn’t think so.
So, let’s add some color to this fair market value definition. In 1959, the Internal Revenue Service published a ruling that establishes guidelines for determining the value of stock in a privately held corporation. While not a statute, this IRS ruling has nevertheless survived for more than 50 years. The key points of this ruling are:
- Valuations are just prophecies about the future based on all available facts as of the date of the appraisal. Valuations do not guarantee outcomes or performance.
- Custom valuations are worth much more than formula approaches to determining value.
- Remember that business valuation is an art, not a science, and a lot more than what can be shown on a spreadsheet goes into the calculation. Common sense, professional judgment, reasonableness and allocation of risk all factor into the valuation equation.
- The fair market value of your engineering firm or a firm you hope to buy will change over time. In an economic recession, for example, you would typically get or pay less for the firm. For more on this issue, read The Importance of Timing When Selling Your Business.
- Professional appraisers (and brokers and bankers) are not always right, and more often than not will disagree on the exact value of the company. Ultimately, you must trust the approach and methodology of the people you engage to determine value, but you must open to understanding when the party on the other side of the deal argues for a different number.
While the “art, not a science” mantra still applies, the IRS has provided some information that may help improve the “science” side of the valuation equation. Factors to consider when valuing an engineering company include the following:
- Nature and History of the Engineering Firm: This factor is key to any valuation equation. For one, the history of the firm shows stability over time, growth, diversity of operations and more – all of which are essential to forming an opinion of the risk of buying that engineering firm or selling that engineering firm.
- Management Team and Personnel Generally: One major factor in valuing engineering consulting firms is the depth and experience of the management team as well as the trained personnel – all of whom could affect the value of the business. As I mentioned earlier in this article, engineering firms generally do not have many tangible assets, so their value is oftentimes locked up in personnel, management and other intangibles like goodwill and client relations.
- Economic Outlook Generally and for Engineering Consulting Industry: Starting broadly, the general economic conditions of the U.S., as well as your local market (Texas and Austin) all impact the value of the firm, but buyers will also look at the conditions of the engineering consulting industry in determining the price.
- Book Value and Financial Condition: Every valuation will involve the engineering firm’s balance sheet and related financial statements to spot issues like liquidity, the “quality” of the fixed assets, working capital and long-term indebtedness, and the capital structure of the firm. An appraiser will pay particular attention to anything that might affect the fair market value of the company.
- Earnings Capacity: To determine earnings capacity for the engineering company or engineering firm, a buyer will examine the income statement for the current period and for at least five prior years. Depending on the age of the business, some valuators even ask for income statements going back more than a decade to see how the engineering consulting firm has handled good and bad economic times.
- Sales and Size of the Block of the Stock. If you are selling stock or buying stock in an engineering consulting services firm, then there are a whole host of additional considerations to be factored into the value you receive or pay. If a buyer is acquiring a minority interest in your company (basically, making an investment in your company rather than an outright purchase of), for example, then the value will typically be less. The premium a buyer pays for full control of the acquired company is called the “control premium.” If the buyer does not get any say in the operations of the company (i.e., because the buyer only buys a small stake and doesn’t have the ability to control decisions), then the buyer will more than likely aim to pay even less for the stock.
- Comparison to Other Firms: Ultimately, the sellers want to make sure you get a comparable amount to what someone in similar circumstances got for a different (but similar) transaction. The buyer, of course, wants to be sure to not overpay. So, both sides have an interest in knowing what happened in similar transactions involving engineering consulting companies in the local market. Data points from similar sales are called comparables. Business brokers and investment bankers who have sold similar companies will have these data points. So may your deal attorney or other advisors.
These factors, along with several more, form the bedrock of any engineering firm valuation. Some are weighted more heavily than others based on the transaction, and each individual transaction may have its own unique aspect that enhances or minimizes the relative importance of certain factors. The bottom line here is that you, as the buyer or seller of an engineering firm or engineering company, need to have professionals doing their job to provide you with an objective measure of the value of your company or the target company.
I know you’re looking for more concrete data. While an oversimplification, in the interest of giving you something more tangible, it’s not uncommon to see small engineering firms sell for 3 to 5 times seller discretionary earnings, which is a measure of earnings that considers the compensation of the seller (the owners) and unnecessary expenses. For a quickly growing firm with strong market position, expect to pay (or receive) more. For a stagnant firm with revenues of less than $2MM (across industries it’s common to see sale price multiples increase as revenues grow because higher revenues generally reflect a business that is more systematized and less dependent on its owner, plus there is more activity (e.g., more bidders) as transaction values increase), multiples may be a little less.
The Due Diligence Process During M&A
Due diligence is a term in M&A for looking under the hood and kicking the tires of the company you are thinking about purchasing. Typically, due diligence involves the request for and review of the legal documents of a business as well as documents related to finances, operations and IT systems. Why do you want to conduct due diligence? Due diligence helps the buyer decide if purchasing the target engineering firm is a sound commercial investment. We generally think of due diligence as a buyer activity, although for the seller, due diligence can confirm that the buyer is serious about the transaction and can afford to pay for your engineering firm.
While deals sometimes fall apart because of information gathered during the due diligence process, more often than not the parties use the gathered information to shift risk back and forth. For example, you might decrease the purchase price of the engineering firm if due diligence reveals a pending lawsuit or some other large issue that the buyer would have to deal with post-closing. Or, as a buyer you might seek stronger representations and warranties and indemnification provisions in the purchase agreement.
Now, both sides are likely going to be concerned about confidentiality. From the seller perspective, you would not want to reveal all your major contracts, for example, to just anyone. From the buyer perspective, you may not want other engineering firms, competitors or the public to learn about the details of the merger or acquisition. So, both parties should be willing to enter into a confidentiality agreement — also known as a non-disclosure agreement — before investing all the time and effort it takes to conduct due diligence. If you are the seller and the buyer gives you a confidentiality agreement, it is time to call your M&A lawyer. Once you’ve got that confidentiality agreement down, then it is time to dive into the due diligence process.
Two additional considerations should be top of mind as you enter the due diligence process: (1) the scope and (2) organization. Both are vital and can help or hinder finalizing the transaction, so you want to make sure your team is on top of both the scope and organization of the due diligence. For the scope element, factors like the deal structure, cost, access to each other’s businesses, and time constraints can all expand or reduce the scope of the due diligence process. For the organization element, it is critical that you have someone on both sides working to organize the due diligence process. Having a smooth, organized plan in place can save a lot of time, effort and stress. The due diligence plan should include things like the scope of due diligence, tasks and assignments, budgets, deadlines, threshold issues, communications process and more. The bottom line is that you need a plan in place before entering the due diligence process.
Once you have that due diligence plan, it’s time to dive in. Starting from the buyer’s perspective, let’s walk through what exactly the buyer will be looking for in the due diligence process. This depends, of course, on the specifics of each purchase of an engineering company, but there some key questions that every buyer will ask:
- Does the seller of the engineering firm have good title to the firm’s stock or assets (depending on which is being purchased)?
- Does the value of the engineering firm make sense based on the available financial documents?
- What liabilities and risks are outstanding and how will they affect the purchase price?
- Are there any barriers that might delay or prevent this transaction from taking place and, if so, how should they be handled?
- What are the operations of the engineering firm?
- What actions will the buyer have to take to integrate the engineering firm or assets of the engineering firm into our existing processes?
- Does this merger or acquisition require any additional documents?
To answer these fundamental questions, the prospective buyer of an engineering company will send over what is known as a due diligence request list, which is an organized list of questions and requests for documents. The buyer will oftentimes send additional due diligence request lists over time, which is why it is important to make sure the due diligence scope doesn’t expand and become too much of a burden. Experienced M&A advisors, such as investment bankers and merger & acquisition attorneys, can help facilitate the due diligence process, making sure it moves smoothly and relatively quickly.
With the due diligence request list, the buyer typically asks for documents like corporate records, contracts and financial reports, but the buyer may also rely on publicly available information (if it is out there). As the seller of an engineering firm, you may also need to make your senior management team available for an on-site visit and to answer buyer questions.
If you are the seller of an engineering firm or engineering company, then you will likely need to conduct your own due diligence of your firm and the prospective buyer in the lead up to and as part of a merger or acquisition. Due diligence can be expensive and time-consuming, so you want to get your documents organized before getting too far into the merger or acquisition process. This helps everyone with the negotiations and drafting process. You also want to look for any liabilities or issues that might devalue your engineering firm to see which ones could be remedied.
You also need to look at the buyer to make sure it can complete the transaction, and you should do so sooner in the transaction. In particular, look at the buyer’s background, history and reputation, check any available financial records, and look for any legal judgments or pending litigation that could impact the buyer’s ability to close the transaction.
The bottom line for due diligence is that both sides to a merger or acquisition will want to verify certain information. It’s natural to want to do that for any major purchases. By keeping things confidential, limiting the scope of due diligence, and staying as organized as possible, you can reduce the due diligence headache and more quickly close the deal.
Structuring the Deal Generally
Now that we’ve walked through an overview of the industry, the professionals you will encounter in the M&A process, handling the purchase price and due diligence, as well as the key operating metrics for engineering firms, it is time to dive into the “lawyer stuff.” That is, how should the transaction be structured?
When an engineering firm owner decides to sell their business, they may choose to sell assets, stock or merge based simply on what the buyer wants to do (or what the broker recommends, which is often an asset purchase because they aren’t licensed to sell stock or perhaps they understand asset sales more than stock sales or mergers). Many times, firms don’t understand the financial and legal ramifications of the transaction structure. So, it’s important to have a reliable business attorney specializing in transactions involving engineering firms who can help guide you through the M&A process and, specifically, structuring the deal.
In terms of structuring the deal, there are three options to pick from: an asset purchase, stock sale or merger. Which one you pick depends on several factors like legal issues involving liabilities and risk, tax issues, the type of entities involved in the transaction, the number and type of contracts to be transferred to the purchase and more.
Let’s start with the asset purchase, as it is the transaction structure that is most simple to understand. When you buy or sell assets, all you are doing is buying or selling specific assets like contracts, goodwill, customer lists, books and records, and other assets directly from an engineering firm. It’s similar in many respects to buying groceries. Sometimes, buyers will also acquire certain specified liabilities that come with the specified assets. At the end of the transaction, both buyer and seller still exist as separate entities, but the identified assets and liabilities have switched hands.
So, what are the pros and cons of using an asset purchase structure instead of, say, a stock sale? For the buyer, there can be many benefits. The biggest benefit is that you can pick and choose which assets and liabilities to purchase and which ones you want to leave behind, which saves money that might otherwise be spent on unwanted assets. Another major benefit is avoiding assuming unknown liabilities or all the seller’s liabilities, as would be the case in a stock sale. Moreover, there can be tax benefits for the buyer if it structures the transaction as an asset sale because the buyer can increase the book value of the assets to fair market value when placing the assets on its books, whereas in a stock sale the book value of the assets is generally fixed (the book value on the seller’s books is what is used to value the assets on the books of the new buyer-owner). Higher book value means greater depreciation, which reduces income taxes.
Sellers of engineering firms may not be as keen on asset sales for two reasons. First, they must retain all known and unknown liabilities. And second, there are typically better tax consequences for the seller of an engineering company if it structures the transaction as a stock purchase (this isn’t always the case and it has to do with the current entity and taxation structure of the seller). So, these two reasons may result in the seller pushing for a stock sale instead of an asset purchase structure.
The next deal structure option is a stock sale, which means buying stock, limited liability company membership interests or any other equity interests from the owner of the engineering company. In this deal structure, the buyer acquires stock directly from the stockholders, which means the buyer also takes all rights, assets and liabilities.
From the buyer perspective, a stock sale may not always be the best option. For one thing, the buyer cannot as easily pick which assets and liabilities to purchase. In a stock deal, all the assets and liabilities transfer with the stock. There are some ways to address this situation by carving out certain items from the sales, although it can be complex. So buyers often must create small subsidiaries or negotiate specific contractual provisions to shield themselves from liability.
Sellers of engineering companies, in contrast with buyers, generally favor stock sales. Why? Because stock sales pass the responsibility for liabilities to the buyer, meaning the seller can usually ride off into the sunset. Moreover, sellers often have better tax consequences from stock sales.
There may be any number of reasons for structuring a deal as an asset sale or stock sale. Either option has its strengths and weaknesses, and oftentimes whichever transaction party has the most advantage can push for their preferred deal structure
A merger is the last option for the parties to consider. Defining a merger is relatively simple. It’s a stock acquisition where two (or more) companies merge into a singular, surviving entity. That surviving entity takes on all rights, assets and liabilities. There are two big buckets that all mergers fall into: (1) direct merger or (2) indirect merger. Within those two buckets, there are several variations of the merger process with names like forward merger, reverse triangular merger and more. But the bottom line for mergers is that there are different ways of structuring the merger to have better legal, tax and business consequences depending on if you are the buyer or seller of the engineering firm. Mergers are not very common with main street-type deals (transactions under $2 million) because they’re more complex than asset and stock sales and usually driven by significant tax considerations that don’t usually exist with smaller companies. Your M&A lawyer will provide guidance on whether this deal structure is right for your firm.
Specific Transaction Tools – The Earn Out, Seller Financing and One-Step vs. Two-Step Closings
Next, let’s walk through a few topics that could be factors in the deal negotiations. The first is called an earn out (or earn-out), which just means money paid out over time based on performance. If the buyer and seller each think the engineering firm is worth considerably different amounts, an earn out might be a good solution that splits the risk between the parties. If after the closing the target engineering firm performs to certain standards agreed to by the buyer and seller (such as growing the customer base or achieving EBITDA or revenue milestones), the total purchase price for the engineering firm could increase. In sum, an earn out is a good way for both parties to split the risk. If you as the buyer of an engineering company include an earn out in your purchase agreement, it might be very valuable to ask the seller to stay on at the engineering firm once the deal closes to ensure certain targets are met. Yes, you’ll pay more given the structure of the earn out, although ultimately that benefits you as the buyer anyway.
In the M&A process, a buyer may ask you, as the seller of an engineering firm, to finance some of their business acquisition by holding a promissory note for a portion of the purchase price (this is a legal document evidencing the buyer’s unconditional promise to pay). Actually, the buyer might ask you to hold a note for the entire purchase price, although I can guess what you answer to that request would likely be! The loan can be payable on demand or, as is most often the case, on a specified date.
If the buyer pushes for seller financing via a promissory note, the seller should determine how it can minimize its risk in financing the transaction. The seller wants to make sure it is paid in full and on time. One key way to do this is to secure the note with buyer assets. This is called security for the loan. It means if the buyer defaults on the loan, you can foreclose on the security and recover some assets to offset your loss. Without security, if the buyer files for bankruptcy, you may not recover much. This isn’t always easy to do, though. It depends often on whether the buyer already has financing on its business. If it has a credit facility, the lender may already have a lien on all the buyer’s assets. While you can try to carve out certain assets (e.g., the assets of the business you are selling is a good place to start) to serve as security for the seller financing, some lenders won’t allow this.
Another issue to consider is whether the deal will be done as a one-step sign and close or as a two-step deal (sign today and close on another date). Why would you want to separate out the signing and the closing? One reason for splitting the two dates out is that the transaction requires regulatory approval. Or, the buyer and/or seller may need to obtain other consents. This could include customer contracts, signings or even meeting with employees. If the buyer is a public company, separating the signing and closing is key because the transaction typically requires board and stockholder approval. Private deals require those approvals, as well, although they take much longer to obtain with a public company, especially shareholder approval if it’s necessary, which it usually is in the case of a sale.
Documenting the Deal – The Asset or Stock Purchase Agreement
Once you have identified the deal structure for selling or buying an engineering company, it’s time to begin documenting the deal. Like the deal structure, there are three types of agreements that you might use depending on the structure of the transaction. For asset purchases, you use an asset purchase agreement, which is also known as a P&S agreement (purchase and sale agreement). For stock sales, you’ll rely on a stock purchase agreement or, again, a P&S agreement. In those instances when the engineering firm is being merged into another company, you will use what is known as a merger agreement. These names are fairly intuitive, right?
Something else that is fairly intuitive is a concept called the “power of the pen.” What this phrase means is that, typically, you want the opportunity to draft the agreement – whatever kind it might be – before anyone else touches it. It’s an advantage to have your counsel prepare the document. Why? When most attorneys review an agreement that they did not draft, they will limit their comments to some degree. So, there is a benefit to being the one to draft the agreement because you can insert all the key provisions you believe are vital to the transaction. Little nuances can make big differences in these transactions, so having the power of the pen can be critical. However, in a direct, negotiated sale, the buyer’s counsel typically prepares the first draft of the purchase agreement. If you are selling an engineering firm, it’s unlikely that you will have the power of the pen at first, which just means you need a skilled business attorney with experience in the M&A space and engineering industry to assist you.
Regardless of the type of agreement, it will contain standard sections. These sections are called the articles and you can think of them as general subject areas in the agreement. A typical purchase contract will contain the following articles:
- Purchase and Closing Details – Purchase price, what is being purchased, when the closing takes place, documents exchanged at closing, and more
- Representations and Warranties of Seller
- Representations and Warranties of Buyer
- Covenants – Covenants might be just between signing and closing or apply post-closing
- Conditions to Closing – Applies only if there are two steps between signing and closing
- Indemnification – this is the promise of each party to make the other party whole (pay damages or defend a lawsuit) if there is a breach of the representations and warranties
- Termination – only applies if it’s a two-step sign and close transaction
Let’s look at some of the more important provisions. Obviously, the Purchase and Closing Details section is vital, as it describes the type of transaction (asset purchase, stock purchase or merger and, if it is the latter, what type of merger) among other vital provisions. Your M&A lawyer will help ensure that these provisions accurately reflect the business deal.
Another very important section is Representations and Warranties. This section is where the seller of an engineering firm represents the condition of the business. In a one-step sign and close the representations and warranties are as of the date of signing. In a two-step transaction, the seller provides the representations and warranties as of the day of signing and the day of closing (the buyer will usually require a “bring down” certificate that says, essentially, all the representations and warranties are true in all material respects as of the closing date. A seller may make 20 or more representations – things such as whether this is litigation, that the assets being sold (or stock) are owned free and clear, that the intellectual property being sold does not infringe any third party’s rights and that the financial statements are true and correct. The buyer of an engineering company will likely also make several representations and warranties, although far fewer than the seller.
And that statement being true can be vital for the transaction. For example, if the seller of an engineering firm does not own the assets being sold (which is a representation the buyer will require), then the buyer has a huge problem. Likewise, if the buyer represents that it has gotten all approvals required for it to close the deal, but made an error of some kind that tanks the deal, then that could stop the transaction dead in its tracks.
The representations and warranties are also important from a liability and risk allocation standpoint. If the buyer is not willing to state, for example, that it has all approvals necessary for the deal, that should raise a red flag for the seller. Similarly, if the seller cannot represent that the assets sold are in good working condition (normal wear and tear excepted), then the buyer will likely want to dive back into the due diligence and verify the condition of the assets. In these ways, the representations and warranties are used to uncover due diligence issues or barriers to closing the transaction.
Other times, the representations and warranties merely shift risk between the parties. For example, if the seller makes a representation to the buyer that there are no undisclosed liabilities affecting the business and it turns out there was something, even if the seller didn’t know about it (for example, an ex-employee may be preparing a lawsuit at the time of signing the purchase agreement, but the employee has not filed the lawsuit or even told the company that it’s forthcoming – arguably this is an existing liability), the seller will be responsible for indemnifying the buyer post-closing. Representations and warranties are heavily negotiated in any transaction and attorneys will fight to include qualifying words, such as “to the Seller’s knowledge,” which, if used in the case of the example above with the unknown employee lawsuit brewing, would not trigger a requirement for the seller to indemnify the buyer unless the seller knew about the lawsuit (and to take it a step further, purchase agreements will often define what it means to “know” something – is it actual knowledge or the knowledge the seller should have if they were paying attention).
Another important provision is the non-compete or non-solicitation section. With this section, you as the buyer of an engineering firm in Texas will try to prevent the seller from selling you their firm and then immediately turning around to open a new firm directly competing with the business or assets you just acquired. That would devalue the main merger or acquisition and could lead to loss of customers or whatever economic value underlies the transaction. In the Texas market, we typically see 3-6 years where the seller of an engineering company or the owners of the engineering firm cannot compete with the buyer.
Sellers may not have a ton of advantage for the non-compete or non-solicitation section of a purchase agreement, but make sure you consult with your business attorney before agreeing to these terms. You don’t want to box yourself out of a future endeavor or better job opportunity – if available.
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:
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.