Focus on what counts

The Vision: Valuation of an Architectural/Engineering Firm: An Overview

May 25, 2016
view all archive

The Vision: Valuation of an Architectural/Engineering Firm: An Overview
Written by: Alan Schachter and Gilbert Watkins

Architecture and engineering firms are required to value their practices at critical stages of their professional operations. These include, but are not limited to:
  • The determination of a fair and reasonable buy/sell agreement.
  • Preparation for the sale of all, or a portion of their practices, to either internal or external buyers.
  • Estate planning purposes.
  • During the course of litigation related to a practice breakup or matrimonial proceeding.
  • Determining the appropriate price for a potential acquisition or sale of the practice.
The value of your practice will be heavily dependent on the facts and circumstances surrounding the assignment, which include the following:

DATE OF VALUE: valuation is determined by what is known and knowable about the practice as of the date of value. Timing of the valuation assignment can be a critical factor.

STANDARD OF VALUE: it represents a definition of the type of value being sought out. There are several different types of value. More often than not, the standard of value utilized for the valuation of A&E practices is fair market value. That is the price to be paid by a hypothetical willing buyer or seller at arm’s length. However, if the transaction results in analyzing the price to be paid for an acquisition by a specific buyer, normally the standard of value will be investment value to the specific buyer, including the synergistic benefits generated to the buyer.
PREMISE OF VALUE: is an assumption about the circumstance under which the transaction will be consummated. Usually the going concern premise of value is utilized in A&E valuations. A going concern is a viable entity which has the requisite assets and work force in place, and its doors will remain open for business with no imminent threat of liquidation.

VALUATION APPROACHES: there are three generally accepted approaches to value A&E firms.
  • Income approach: includes the capitalization of historical earnings or the discounting of future cash flow. The aforementioned methods include the consideration of the time value of money as well as the risk of achieving the projected valuation amount. The process of determining risk is embodied in the appropriate capitalization rate or discount rate.
  • Market approach: relies on comparing the calculated value of the firm to the value arrived at in comparable market transactions gathered from or published by A&E databases.
  • The cost approach: accumulates the value of the company’s net assets beginning with and building upon the accrual basis net asset value of those net assets.
  • Valuation Process: a historical analysis of the reviewed or audited accrual basis financial statements provides a good starting point for the valuation process. The amounts reflected in the income statement and balance sheets may require normalization. This could include adjusting excess owner’s compensation, other excessive operating expenses, and balance sheet accounts. When using historical earnings/cash flow we will often use a weighted average of the last five years; this tends to smooth out the years of volatility, usually giving a greater weight to recent history. Future cash flow projections should be supported by realistic operating assumptions.
The valuation process will require the valuator to obtain a great deal of external and internal data related to the A&E firm being valuated. This data includes: national, regional and local economic data, demographics, the firm’s level of technology, competition in the marketplace, regulatory compliance, client base, nature of the services provided, level of profitability, firm reputation, quality and compensation level of the assembled workforce, adequacy of the office space and the terms of the lease, and heavy dependence on key employees. This data will be woven into a narrative dealing with the strengths and weaknesses of the practice and will serve as a cornerstone for the previously mentioned risk assessment.
The valuation approaches selected will usually result in a range of possible values. One must understand the nature of the key value drivers related to A&E firms. These value drivers will include:
  • Continuity of profitable valuations over a number of years with steady growth. A great deal of volatility is frowned upon.
  • The firm’s reputation, which would include the quality of prior projects performed.
  • The quality and geographic dispersion of the client base.
  • A healthy back log.
  • Employees with unique areas of expertise.
  • A quality infrastructure, which would include equipment and software.
  • Strong cash flow and access to sufficient capital so as to weather poor business and economic cycles.
  • A strong staff with depth in multiple areas.
After determining the preliminary valuation amount, the valuator must give consideration to the appropriate discounts related to lack of marketability and lack of control. Marketability deals with the owner’s ability to convert his investment to cash in a relatively short period of time. The discount for lack of control deals with the inability of a minority interest, if it exists, to make critical economic decisions for those internal personnel who are acquiring it.

As a norm, the value of an internal ownership interest is often lower than the valuation for an arm’s length transfer to a third party because very often the value of the A&E practice may come for those who are acquiring it.
Those who are not familiar with the valuation process do not realize the complexities of an appraisal performed under generally accepted valuation standards. They believe that value can be determined by rules of thumb, which anyone can apply to the revenue earnings or book value of the practice. A rule of thumb does not give any consideration to the nature of the risks and the results of operations of the specific practice being valued. The best approach to value your firm is to have a valuation prepared under professional standards by an accredited business appraiser. However, rules of thumb can be used to develop a range of values for the practice, and they should only be used as a check for reasonableness and cannot be relied upon for the accurate determination of value. In addition, investment bankers, regulatory agencies, bankers, and others schooled in finance will most likely not accept a value determination unless it is contained within a well-documented valuation report.

Written by: Alan Schachter and Gilbert Watkins