By Brad Wilson, Senior M&A Consultant, PSMJ Resources
Summary
If you are a firm leader looking to retire, ownership transition is probably forefront in your mind. Looking at internal sales of stock ownership, processes, and partnership agreements, however, much has changed since the 2008 downturn. Generational forces at work in today’s architecture firm present a major challenge to effective ownership transition.
Thus, as a firm leader, you must do more than consider new or revised terms in your buy-sell agreements. To be successful, you need to start grooming your successors long before you decide to take your exit.
Today’s perfect storm
Internal ownership transition has become one of the most difficult things to do today. In fact, we have just run into what could be called the “perfect storm.” The number of baby boomers who own shares in the architectural industry and want to get out is at an all-time high. It is going to get higher yet, but it is peaking with the current demographic of firm owners.
While current boomers are looking to retire, however, few Generation Xers are ready to take over the reins, and the following generation—millennials—have different expectations. Also, many of these younger folks coming up the line are still shell-shocked from the recession. They saw themselves and all their friends get laid off. Also many—and I hate to generalize this—have an entitlement attitude. They expect to be given the ownership; that, in effect, they have already earned it by being a good employee.
Because of a reduced demand for shares inside the firm, there are not a lot of buyers out there for internal ownership. And, of course, this doesn’t fit with the retirement plans of the Baby Boomers, many of whom are behind schedule because of the losses they incurred during the recession. And so, when you combine a pressure for value with the fact that the younger folks don’t want to pay, the result is nothing less than a logjam.
Deep discount vs. external sale
We see a big separation in valuation between what a seller—who owns shares and wants to sell—can get from an outside firm versus what they could possibly get with a discount sell to an internal shareholder. Also the difference between internal and external sales has become much starker. We used to see a 25-30 percent discount from an external to an internal sale. Now we are seeing double that, at least a 50-60 percent difference between what firms could sell themselves for externally versus internally.
It gets down to what the outside buyers are willing to pay versus what the inside buyers can afford. Sellers are looking at the situation and saying: These younger folks seem to be hard workers, but they have an entitlement attitude and they don’t have any money. And I can get so much more if I sell outside, why wouldn’t I do that?
Firm leaders, however, should not assume that an external sale is always a good fallback position. There’s a good chance that the younger folks would not come along in a sale. For sellers to be able to deliver firm value, they have to be able to bring their key staff with them. And so, the process is circular: it runs right back into itself.
To say it another way, retiring baby boomers must consider how an external sell would impact firm culture. Moving from an internal to external sale greatly increases the influence of money on your decision. If you have operated a practice-centered business for a generation, and then all of a sudden you need to get the place ready for an outside sale, you are now money-motivated.
Thus, when you change to a business-centered practice to make more profit, the firm falls apart. The middle management does not get it: They joined and stayed at the firm because of the way it operates. You might be able to turn a screw here or tighten up a bolt there, but the culture turns very slowly even in a small firm. Making the switch from an internal to an external focus requires whipping your firm into the opposite direction, and it’s likely that your employees will not come along.
ESOPs find new popularity
Employee stock ownership plans (ESOPs) have become more popular. They’re less overhead burdensome then they used to be and less expensive to set up. Some firms put an ESOP in place as a last resort for ownership transition. They think: “We don’t want to sell to a big firm and we can’t sell internally, so let’s do an ESOP as a fallback position.”
The problem is that an ESOP comes with a cultural change. And firms often don’t understand how an ESOP shifts the culture of the firm into one where everybody is now an owner. Sometimes firms prep for that and do some lead-up. If firm leaders talk it up and become more open book, than the firm may not change in bad ways.
But generally, our view has always been that you can’t make people act like owners just by giving then stock. People need to act like owners first, and then an ESOP might be a good solution. You can’t do it in reverse.
Financial planning for ownership transition
Many firms want to stay independent. Their owners say: “I don’t want to or I don’t think I could sell to an outside firm, and I don’t want to stick around here very much longer. I have to do whatever it takes to make this go.” And so, in order to induce the younger folks to buy, buy/sell agreements are becoming much more negotiated in the favor of the buyer. This includes much more financial assistance to the buyers, reductions in valuations for the firm for internal transition, and less-restrictive non-compete clauses.
The other thing firms are doing in the good economy right now is finding ways to maximize profits, and then increase the distribution to the owners as much as possible. If you can absorb the discount to keep the firm independent and give it to the next generation—and you can sell it at a value they are willing to accept—that’s great.
Prior to that, however, the firm would have had to set up an earnings club, i.e. where as much profit as possible is distributed each year to the shareholders. You have to maximize that for a few years, and then hand it off to the next group of leaders. Maybe they are prepared to handle it or maybe it’s the death of your firm. You never know, but as the baby boomer, you have your money at that point. Firms interested in staying independent in this way need to begin planning at least 10 years in advance.
Time to invest in young entrepreneurs
We also find that firm owners often turn to an outside sale as a fallback position because they have not done any leadership development or mentoring. In about 4 out of 5 assignments that we do, the owner wants to sell internally, and finds out that he can’t.
So if you’re considering an internal sale, start by investing in your younger employees now. Grab your top two entrepreneurs and train them up. This means investing in your people even before you consider an ownership transition.
If you want to have the choice of selling internally, you need to grab people early in their career and invest in them. Find someone you know who has 6-8 years before they’re ready for ownership. Provide them with management and business training. Make sure they understand all of the services you offer and all of the types of clients you serve. The goal is to give them a broad base of experience, and not let them get pigeon-holed.
It is by sharing information with your entrepreneurs—showing them the way the firm operates, how much money it makes, and how much money it costs to keep the place open—that you begin to generate an ownership mentality. This should be job number one or you are not going to get out the way that you want to. You are multiplying your choices the more time you spend with your young entrepreneurs.
Then, if they choose—their eyes are completely open and they have complete understanding of the challenge, that’s great. And if they choose not to buy—because they don’t want it or their situation doesn’t allow—then you have the opportunity to say: “We gave you the chance. Now we have to sell externally because I am 65 and not getting any younger, so are you sure?”
If you have been down that path, an external sale is the best scenario, and is the way the transition has to be managed. It is all about not letting yourself get painted into a corner. Don’t wake up some morning at age 64 and say “I want to retire in a year, so I better do something about it.” That’s the worst case scenario because you will never catch up.
The interest in selling firms internally is probably at an all-time high, and is going to continue to increase as the baby boomer generation works its way out of the A/E industry. Some firms prepared for this, have done it well, and were ready. Still, the number of external sales versus internal sales has really gone to the external side in the last couple of years. Father Time is ticking away on them, and retiring firm leaders have to do something.
Checklist on general principles of ownership transition
You need to take every opportunity to prepare yourself before you make that big leap. So get to work on this ownership transition checklist today!
_____ There is no single one right way to do an ownership transition.
_____ To keep talented people, you need an ownership transition plan.
_____ Consider internal transition before you look outside.
_____ Preparing your successors is one of your major leadership responsibilities.
_____ The firm has to fund an internal transition.
_____ Know whether you’re creating a culture of empowerment or a culture of control. This will affect all aspects of your transition plan.
_____ Ownership is not leadership.
_____ The next generation of leaders should have a personal financial risk in the firm.
_____ Plan everything. Don’t leave anything to chance.
_____ There’s no such thing as “equal partners.”
_____ Remember the rule of thirds: one third of revenues should go into retained earnings, one third to employees, and one third to the principals.
_____ Build your plan on actual revenues, not the assumption of increased revenues.
_____ Understand the value of your firm: it’s worth only what someone is willing to pay for it.
_____ No company should be liquidated. Any firm can be sold.
_____ Review buy/sell agreements every two years.
_____ Don’t get lawyers involved until you’ve already decided what you want to do.
_____ Make sure lawyers and accountants understand that your assets are your people.
_____ The ultimate transition question for an owner who’s leaving is: What are you going to do after you sell?
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Brad Wilson joined PSMJ Resources, Inc. in 2002 as one of the senior Mergers & Acquisitions consultants. Since, Brad has facilitated both the purchase and sale of A/E/C firms of all types and sizes. Brad’s hands-on assistance with valuation and deal structuring has allowed many PSMJ clients to achieve their strategic growth goals or their ownership transition through a merger or acquisition. His broad-based knowledge of design firms’ cultures and operations has also been invaluable in integration planning and execution resulting in the achievement of financial goals for buyers and sellers. Additionally, Brad regularly facilitates PSMJ’s CEO Roundtables on Mergers & Acquisitions.
(Return to the cover of the 2016 PM Digest: Ownership Transition)