This interview with Hobson Hogan, principal at ZweigWhite, which offers management consulting and valuation services to the architecture and engineering industry, was conducted and condensed by Christopher Parsons.
Christopher Parsons: What’s different about the way that we do valuations and acquisitions in architecture and engineering compared with other industries?
Hobson Hogan: Architecture and engineering is a very people-oriented business. The true assets are the very bright people who are designing, managing projects, and getting the work done; they’re the assets. People don’t really reside on the balance sheet from a financial perspective. You see their work manifested in the income statement, but there’s no really good financial way to measure what they bring to the table on the balance sheet. That’s different than an industrial business that has a lot of fixed assets.
From a valuation standpoint, and especially in transactions, it tends to make architecture and engineering firms a little more risky and difficult to value, because people have free will and can leave at any time. While some firms do have some intellectual property, the true value of most architecture and engineering firms is the ability for the people to get work and do the work, over and over again. That means happy clients and happy designers.
CP: Tom Stewart has written two excellent books on knowledge management, Intellectual Capital and The Wealth of Knowledge. Stewart’s taxonomy for looking at intellectual capital is broken into three types: human capital, which is the people themselves; structural capital, meaning the databases, the process, the patents, and the knowledge firms put into systems; and then the relational capital, meaning all of the clients, consultants, partners, and vendors. Is analyzing structural and relational capital part of your methodology for valuing architecture or engineering firm?
HH: Without a doubt. By the time a buyer sits down and talks with the acquisition target, they’ve typically already reviewed the financials and have a pretty good understanding of them. What buyers are trying to determine through face-to-face meetings and due diligence is: How repeatable is this business? Has the firm relied on one rainmaker who’s got maybe two years left? Is the average age of the designers young or is it a little bit older?
If there’s a firm that has brilliant people who have been practicing for twenty or thirty years, has a great history, but didn’t lay down a foundation of knowledge infrastructure, the buyer is not going to look at that as a sustainable process, as opposed to another firm that maybe is not as brilliant, but has invested time and money in infrastructure. Solid knowledge infrastructure assures the buyer that financial results of an acquisition target are sustainable beyond a handful of stars in senior leadership.
CP: The first time I saw you speak you explained that there are only three endgames for any company: you’re either going to wind it down and go out of business, there’s going to be an internal purchase, or there’s going to be an external purchase. What I took away from your talk was that your company is for sale — whether you acknowledge it or not. What’s the difference between the mindset of the internal buyer and how they determine value, versus the external buyer and how they determine value?
HH: That’s a great question. From an external sales standpoint, I think that the tendency is towards maximizing the return for the shareholders. Does that mean that buyers take the highest offer on the table 100% of the time? The answer to that is no. Sellers have a certain value expectation in mind, and once an offer meets that, then there are some other non-financial considerations that they evaluate. They may go with the firm that they think is the better fit for the folks that are going to remain in the organization or who has a higher likelihood of success in the future.
Internal transactions are usually done over time, so you do not have to maximize the sale of your stock at any given time because you still have ownership of the company. You participate in the appreciation of the stock if the firm does better, and you’re getting your distributions if your firm has them.
One thing that I found over my career is that there’s usually not a material difference between an internal and external sale from a value perspective. If you take a transition process over a five-to-ten-year period, the owner’s total return of ownership, as I call it — the sale of your stock plus any distributions that you receive — usually isn’t that much different than it is from selling externally. What you’re really deciding is when you want to take your money and what risk you want to have.
CP: Speaking of risks, do you think that external or internal sales are more risky?
HH: The risk of an external sale is that you throw a party and nobody shows up. You put the firm on the market and there are just no takers for whatever reason. Selling your firm is not easy. It’s a distraction. Management often takes their eye off the ball because they’re worried about the sale process. Going through a long sale process with no buyers at the end is demoralizing and can harm a firm, especially if the senior leadership has “checked out” from being engaged in the firm. At the end, you still have the internal option; however, those transitions are typically done at a lower value because the external sale option has been exhausted.
With an internal process, there’s the risk of the younger generation not being up to snuff. The firm starts selling shares internally, the exiting generation starts to back away from the business, and then the business falters in the middle of the transition. The remaining shares that the exiting generation have not sold are worth less than they were at the beginning of the sale, so the sellers are likely to achieve a value less than they were expecting.
Those are somewhat extreme examples, but in a firm that would have a strong external market or would perform well in an internal transition, it’s more of a risk tradeoff than it is just, “If I sell it internally, I get X; and if I sell it externally, it’s going to be X-plus.” When you break down the numbers, it’s typically not that big of a difference. It’s more of a question of which risks you are more comfortable with taking.
The interesting thing about how firm valuation relates to the sustainability of earnings and having the knowledge of your firm systematically ingrained — is that you benefit either way, whether it’s an internal transaction or an external transaction. Both external and internal buyers value knowledge infrastructure because it helps to mitigate the risk of the next generation not performing up to expectations and being able to finish the transition. If you have been investing and reinvesting in the firm, reinvesting in the people and their skills and capabilities, and they’re following a process that helps to do work, get work, and make the work more repeatable, you are going to get a higher valuation externally and mitigate the risk in an internal transaction. It doesn’t matter which road you are going down, reinvesting in the skills and capabilities of your people is going to pay off either way.
CP: Perhaps one difference between internal and external transactions from a knowledge strategy perspective, might be that you have more time for the next generation to figure out how to make the business more repeatable as the transition happens?
HH: Correct. If you say you are going to sell externally in a year, there is only so much you can do. There is a point where you start saying, “That’s a great idea. I’m sure that the next owner will get to that.”
But if you are looking at an internal ownership transition, which is typically anywhere from a five to ten year process, you do have time to implement a lot of things to help ensure that the next generation maintains or even increases the capabilities and performance of the firm.
CP: Let’s say the CEO of an architecture or engineering firm approaches you and he or she knows that they want to have options in five years. They are open to selling the firm internally, but suspect it may be an external sale. What are the things that they should start working on now to make the firm more valuable in the future?
HH: First and foremost, is it being people-centric in terms of identifying your future leaders and getting them involved in the management of the business and ensuring that they have increasing responsibility. One of the worst situations that I can find myself in when representing a seller, is that I find a very seasoned management team that has a very short shelf life. They have been doing great, and the firm has been doing great, and the buyer looks across the table and says, “Well, you know, this is fantastic, but who’s going to do all this when you all leave?” And when you look at the next rung of the ladder you find that there’s zero experience.
CP: You told me in a prior conversation that you have a litmus test which asks, “Have the CEO and senior management team taken vacations in the last year?” Why do you ask that question?
HH: If the senior folks can’t go off for a week without feeling like the office is going to burn down, you are going to be out of business. It’s a really big issue if you have leadership that has to be in such control that every little decision has to go through them. Because in the diligence process, and even in the sales process, buyers are going to want to make an assessment on the depth of management and who is going to run the ship in the future.
CP: How else can you tell if a company does not have the next tier of management prepared to lead?
HH: Before we have our first management meeting, I will sit my client down and prepare a presentation for potential buyers. If the senior leadership has a very strong personality and tends to suck the air out of the room, so to speak, I will specifically assign things for the next generation to talk about. I will tell my client that they have a goal, and that goal is for the senior leadership to say nothing, very little, besides the introduction, “You know, this the firm and this is how it got started,” do the history, and then sit on their hands. And that can be very difficult and uncomfortable for certain personalities.
Now if the senior leadership will be in place for the next ten years and will continue running the show, then I want them to shine. But it really comes down to: Who is going to be there over the next five years and who is going to be responsible for making things happen? Whoever that is has to be able to speak eloquently about the business, understand the business plan, and speak strategically about where the firm is going.
CP: It sounds like these basic things are good things for your company whether or not it is for sale. If it turns out that you want to sell it, well super, you are in good shape.
HH: All of these things help increase the value of the firm in an external sale. If you go the internal route, investing in people and infrastructure mitigates a ton of risks. If you are going the internal route, it’s all about risk mitigation, and if you are going the external route, it is about enhancing value.
Ultimately the investment that you make in your people and infrastructure, investment in systems, computer systems, databases, what have you, the infrastructure for capturing knowledge and managing knowledge, and helping people just generally be more efficient or capable at what they do, is going to make them happier and they’re more likely to stay. Happy employees, happy clients, and a repeatable business model all drive up the value of an architecture and engineering firm.