Maximizing value for your firm requires careful planning, expert advisors and a complete understanding of all potential obstacles.
Selling your business is a life-changing event. You go from working more than forty hours a week, including many or most nights and weekends, to not working or working part-time. Selling your business at maximum value, should you choose to, protects your legacy and ensures that your employees continue to have jobs. Successfully selling a business, whether to a group of your current employees (an internal sale) or a third party (an external sale), should be planned and implemented over many years. Developing realistic expectations concerning the sales process, how long it takes, the expenses involved, the value of the business, and transferring the business will almost certainly require the assistance of an advisor(s) and attorneys.
This article mainly targets the seller, but there is always a buyer. Many engineers starting in the profession never dream of owning their own company. But as their careers develop, many engineers start to consider investing in the firm they work for, buying a part of it if the owner makes an offer, or buying it individually or in a group, so there is still much valuable information to be learned.
What Are You Selling?
A buyer is purchasing the future cash flow of the business. Unfortunately, no one knows how much money the company will generate in the future. Therefore, potential buyers look at key indicators that provide insight. For example, there is a strong correlation between future cash flow, the company’s past cash flow, the number of employees, and the employee’s skill level (measured by experience, professional licensure, status in the industry, etc.). Buyers like to see employees across all age brackets, not top-heavy with senior engineers with shorter remaining careers or bottom-heavy with many inexperienced engineers. Employees with a breadth of experience capable of performing multiple tasks or working in multiple engineering fields are more valuable than employees with only one skill.
Another key indicator of future cash flow is the company’s current clients. Repeat clients are more valuable than single-project clients since it is expensive to develop new clients. Clients referred from a center of influence (COI) are highly valued if the COI makes consistent referrals. A COI could be a large government entity or a senior management group in a corporation. Commercial, institutional, and government clients are more valuable than individual customers who might require services only once. The pipeline of signed contracts for future work (backlog) is also essential as buyers focus on future work, which indicates future cash flow. In a typical consulting practice, six months of signed contracts is a healthy pipeline; however, this could vary depending on the nature of the clients and types of projects. For example, some engineering firms working on large institutional projects (hospitals) or large multi-year government contracts (federal or state Indefinite Delivery/Indefinite Quantity (IDIQ) types) have large and lengthy backlogs. Buyers also look at the report of outstanding proposals and try to determine the amount of additional potential revenue.
The history of past projects is the foundation for the company’s name and reputation in the marketplace. The better the history, the better the reputation, and the easier it will be for the new owner to maintain existing clients, obtain future work from them, and leverage past work for new contacts and projects. A company with consistent and increasing sales is considered to have a strong position in the marketplace and can be more valuable than an equivalent-sized but more static company. Profit margins are also a key factor. A company that prices its services at a lower price (therefore assumed to make less profit per unit of staff time) is less desirable than a company that prices its services at a premium price. In a competitive marketplace, a premium price is almost always associated with a superior service offering, niche market, or skill that clients highly value. The percentage of sales wins compared to sales losses also indicates the company’s position and reputation strength. The seller can increase the value of the business by collecting this information over several recent years so it can be shared with potential buyers.
Another key factor in the valuation is the owner’s involvement in the business. While it is understood that the owner is highly involved in almost all aspects of a small business, there is a difference between involvement and total control or micro-managing. For example, an owner thinking of and planning for a future external sale should encourage employees to be the primary contact for some clients, make the board of directors and sales presentations, network with clients, and generally operate and market the business. The goal is to have the face of the company be more than that of a single person. Involving the staff in non-technical activities benefits an internal sale because the buyers will clearly understand the potential benefits of ownership.
A significant risk to an external buyer is that key employees may leave after the sale or after the sale is announced. Key employees generate substantial revenue in a well-run and valuable business by running projects, capturing new clients, and maintaining existing client relationships. The buyer will want to retain these employees. Providing retention bonuses is a common solution to decrease the risk of employee turnover. This barrier also increases the cost for another company to poach the employees or for the key employees to leave to start their own company. The owner contemplating or planning for a sale increases the value of the business by always maintaining positive relationships with the staff to mitigate the risk. Disgruntled or indifferent employees are not valuable to a buyer.
Buying a Business – The Buyer’s Perspective
Potential buyers of engineering businesses typically consist of other engineering companies, key company employees, and third-party individuals. Each buyer has different motivations and interests. Therefore, the owner contemplating a sale needs to ensure that each potential buyer type sees maximum value.
Existing companies or third-party individuals may buy a business as a strategic plan to gain a solid foothold in a new market or add new services in a market they currently serve. This immediately results in acquiring additional customers, employees, and a pipeline of future work.
For small businesses, the most likely buyer is frequently an employee or employee group. They are familiar with the business and see its value. They are familiar with the clients, employees, systems and processes, and culture. Using federal Small Business Administration (SBA) financing, the employee’s down payment may be as little as 10% of the purchase price.
Selling to an internal group can be more complicated than selling to outsiders. Although paid for their work, existing employees will generally believe they played a critical role in establishing the company as it currently exists and in its past successes. They might seek a significant discount over what an outsider might pay and use the leverage of leaving to obtain the discount they seek. Sellers need to face the reality that setting up a new engineering business is relatively inexpensive (renting office space or working from home today, buying computers and a phone system, etc.) compared to a business with significant amounts of plant and equipment or physical inventory. The key internal employee group is in a position to poach themselves and the key client relationships they have helped develop over the years. To avoid this showdown, a seller wishing to sell internally should develop a long-term ownership transition process that involves many individuals. The seller can end up with a much-diminished sales value by waiting too long.
How Much Is Your Company Worth?
Business value is a range as opposed to an exact value. The science of business value is calculating the cash flow. The most common standard is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). However, the Seller’s Discretionary Cash Flow (SDCF) is used for smaller businesses because an owner can pull money from the business in many ways. The cash flow is multiplied by a factor to determine the estimated value, or a series of future cash flows can be discounted to the present to determine the present value. The art is in determining the factor to be applied or the discounting interest rate to be used, depending on the method used. Businesses with more revenue, income, and cash flow demand a larger factor. A simplistic rule of thumb is that the value of an engineering business ranges between 40% and 80% of gross sales. If the discounted cash flow method is used, the art is developing an appropriate risk-adjusted discounting rate and accounting for future revenue growth opportunities. Small differences in assumptions can have a significant impact on the calculated value.
The Sales Process and Beyond
The sales process requires a team of experienced advisors who sell professional service businesses. Your deal team members are your spouse, your accountant, a business transaction attorney, a financial advisor, and an M&A (mergers and acquisitions) advisor. The following description provides an overview of an external sale, but many of the same steps are taken for an internal sale.
The pre-planning phase is when the M&A advisor values your business and writes a Confidential Business Review (CBR). The CBR provides:
- An overview of your business and services,
- the history of the company,
- the services provided,
- types of clients, and
- a detailed discussion of the financial performance.
The pre-planning phase is also when you should prepare for the buyer’s due diligence (audit). Potential problems can be corrected or mitigated at this stage without time pressure. For example, if a buyer receives requested documents within a day, the buyer gains confidence in the seller and business. Conversely, the buyer loses confidence if it takes too much time to receive the document.
The M&A advisor markets your business in a manner that attracts the interest of prospective buyers without revealing sufficient information to allow your business to be identified. Confidentiality is of utmost importance because your clients may choose to shop around if they know your business is for sale. In addition, your employees may choose to control their destiny and leave during a time of uncertainty.
The M&A advisor pre-screens all prospective buyers and requires them to sign a confidentiality and non-disclosure agreement before they learn the name of your business. Then the M&A advisor provides the CBR to the prospective buyer.
A buyer/seller interview follows this. The buyer is seeking to learn more about the business. The seller will assess if they trust the prospective buyer with their business. Both parties evaluate whether they can work with the other party. The seller is selling the business they created, so there is a greater sense of attachment than if they were selling something with less personal investment.
Afterward, the buyer may request more sensitive information such as tax returns, pipeline reports, accounts receivable aging, payroll register, etc. This allows the buyer to understand the business better, which helps the buyer to make a reasonable offer. At this stage, the seller is more comfortable with the prospective buyer and is willing to release the information.
This is followed by the buyer making a non-binding written offer. The purpose is to outline the transaction sufficiently to ensure a meeting of the minds. Critical aspects of the offer should include the purchase price, when the payments will be made, and what is included and excluded from the purchase. For example, engineering businesses typically require the seller to work for the new owner for a certain period and achieve certain financial metrics to ensure a smooth transition between employees and clients. This should be included in the offer.
The attorneys formalize the offer in a legally binding purchase and sales agreement. While the purchase and sales agreement is being negotiated, the buyer should apply for bank financing if needed.
The bank’s involvement provides extra assurance to buyers as their interests align. In addition, the seller benefits from the bank’s participation by receiving more or all of the sale proceeds at closing. The closing is when the papers are signed and the business is transferred to the new owner.
After the closing, a primary component of selling the business is informing your former employees and clients that you sold the business. A good way to inform your employees is during a breakfast meeting the day after the closing. Immediately after informing your former employees, introduce the new owner. First, the new owner should assure the employees that they still have a job. Then, the new owner should meet with each employee individually.
The seller should rank clients: A, B, and C. Then, the former and new owner should conduct in-person joint visits with the A-level clients, in-person, Zoom meetings with the B-level clients, and phone calls with the C-level clients. We suggest multiple joint meetings to ensure a strong bond before the new owner meets with a client alone.
When selling your business, be flexible. The seller should not take a hard stand on any issue until or unless it is required. An open mind and controlling your emotions can make a huge difference. Selling a business in actual calendar days and hours invested in the process is time-consuming.
Conclusion
Your business has value because of its name, reputation, book of business, skilled employees, and ability to generate money in the future. However, the owner should be a part of the business and not the business. Therefore, a team of capable, experienced advisors is needed to help you sell your business.■