By Hugh Hochberg, BS and BArch (RPI), MBA
Of the many strategic and operational things that get owners’ attention, high on the list is evolution of ownership. However, addressing it as an ownership issue dramatically understates and misrepresents the challenge and the opportunity. The real issue for most firms is expansion of leadership and ownership, followed by transition (in the context of not just change, but also divesting of ownership). In other words, at least 90 percent of the time the first change is that the leadership and ownership groups expand and the next change is that some owners divest ownership, which may or may not coincide with their departures from the firm.
To simplify the overall picture, it can help to consider the difficulty of various transition components. From least to most difficult:
- ·ownership transition
- management transition
- governance transition
- marketing and business development transition
- leadership transition
Let’s look at each transition:
Ownership Transition
Ownership transition, though not necessarily simple, is mechanical in nature. Determine how to value ownership, decide how to price it—recognizing that sellers can adjust the price circumstantially—and recognize the critical truism: There is no such thing as truly successful ownership transition in marginally profitable firm, if one agrees that “truly successful” means providing fair value to sellers, being affordable to buyers, and serving the best interests of the firm by bringing the right people into ownership at the right time.
One of the “rules” about transition is that no rules apply universally except for the above truism. Having said that, some empirical data from a large database might help:
- To keep financial data in simple terms, the average valuation for internal transition purposes equates to 25 percent to 30 percent of annual net revenue (defined as gross revenue less consultants and non-labor project expenses).
- The average valuation for external transition—sale to an outside buyer—is about twice the internal price, or 50 percent to 60 percent of annual net revenue.More highly valued firms can sell for as much as 100 percent of annual net revenue or more, but that’s pretty rarified air.These external values are the “goodwill value”, which value above the liquid value (primarily cash and receivables).
- Minimal operating profitability (before retirement plan contributions and bonuses) to sustain pay competitive compensation and fund ongoing, incremental ownership transition is 10 percent of net revenue, which explains why so many firms deferred ownership transition during the economic downturn of 2008-2012, when average profitability dropped to 5 percent.
- Sellers who expect to get rich or fund their retirement exclusively from the divestiture of their ownership will be disappointed.The compensation math clearly demonstrates that an owner for 30 years in an architecture firm is likely to receive over 95 percent of remuneration in the form of salary and distributions and less than 5 percent from the sale of ownership.
- Over-pricing ownership will lead to departures of the next leaders and owners, because if they are good enough to be successors, they are good enough to be competitors.
The overview nature of this paper precludes delving into details of mechanical considerations, which include such realities and complications as tax considerations, timing, terms, internal and external funding sources, and more, each of which requires considerably more space than is feasible here.
Three more transition components
Management transition, referring to orchestrating people and resources, is relatively simple because most people follow managers’ instructions even if the managers don’t particularly enthuse them.
Governance transition, referring to participation in the highest level decision making about strategy and policy, is more difficult for a few reasons. One is simply the magnitude of the issues which governance addresses. Another challenge is that with expansion of the governance group, new dynamics and relationships develop, and a governance group’s effectiveness depends in part on the ability to air different views and come to good decisions in a timely way. Excessive deference by newcomers to established members impedes achieving highest effectiveness.
Marketing and business development transition is a more difficult and more significant challenge, to large degree because people with the capability and passion to do those things well are few and far between. To the chagrin of many, simply being a competent practitioner—even with a focus on a specific typology—isn't enough. Another difficulty is the time it takes to earn credibility in the marketplace, and too often the expectation is too much too soon, so the effort ends before results can reasonably be expected.
Leadership transition
Leadership transition usually presents the biggest challenge, and the reasons warrant clarity. First, leadership has a fuzzy definition, with many people equating leadership with management. The real test of leadership is followship: If there’s no one following you, you’re probably not leading. A second challenge is that many leaders are entrepreneurial, and as a result they often seek to create new opportunities rather than advance in existing organizations.
A third challenge is that leaders are often impatient, which leads them to depart before the generation ahead of them thinks they are ready to step into leadership and/or ownership roles. This emphasizes generational patterns, with first generation ownership characterized by entrepreneurialism and external focus (evidenced by the ability to bring work) and second generation characterized by focusing on doing the work, developing the systems and processes for delivering work, and exhibiting patience (becoming owners at an average age of 41, whereas the average age of founders when they start their firms is 31).
In this overly simplified model, the third generation is more like the first than the second, and the patience of the second generation can impede leadership evolution. A firm needs the strengths of both first and second generation profiles. Absent one or the other, the firm’s chances to succeed diminish considerably.
Lessons learned
Considered together, these various transition components tell us several things:
- Identifying, developing, and retaining future leaders is the biggest challenge. In other words, the “who” is far more often the bigger transition challenge than the “how”.
- It is wise to institute a transition plan early, and concentrate on identifying, developing, and retaining future leaders and owners
- Profitability is a necessity, and attaining the average of the profession in most years is barely enough.
- Greed hurts transition.
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Hugh Hochberg, BS and BArch (RPI), MBA (Harvard), leads The Coxe Group and has personally consulted with over 1,150 professional service firms, and the success of many have earned high respect from their peers. His wide and deep involvement includes virtually every aspect of practice. Among the clients with which he has worked, one-third are winners of the AIA Firm Award. Hugh practices nationally and lives in Gig Harbor, Washington.
He has taught and lectured at numerous highly respected universities and conducted programs for many professional societies in North America, Asia, Australia, and Africa. He has also written for several publications, including Progressive Architecture, Architecture, Design West, Oregon Architect, Oregon Business, and the AIA Handbook of Professional Practice and co-authored Success Strategies for Design Professionals (McGraw-Hill). He has been a contributing editor of DesignIntelligence and has been interviewed by National Public Radio (NPR). He can be reached at hhochberg@coxegroup.com.
(Return to the cover of the 2016 PM Digest: Ownership Transition)