Insights and considerations that can help you decide if you’re ready to buy another firm.
Over the last several years, the AEC industry has seen unprecedented consolidation. The reasons for this vary, but one primary use for a merger or acquisition is as part of a growth strategy. AEC firms have found that the available talent pool is dwindling, and multiple firms are chasing the same few candidates. To put this into perspective, according to the Bureau of Labor Statistics, the unemployment rate for experienced architects and engineers as of March 2023 was 1.30 percent. This is lower than the long-term average of 3.10 percent. M&A allows a firm to quickly acquire staff as well as clients, projects, service offerings, market penetration, and even geographic expansion.
While M&A can be a powerful and successful growth strategy, firms considering this option often aren’t sure where to start or if they can afford to purchase another company. To that end, this article shares a few insights and considerations that can help you decide if your firm is ready to go “buy side.” A few things to consider:
“Lifestyle firm” to a “growth firm.” Generally speaking, a lifestyle firm works to maintain a strong work-life balance for their owners and their staff. They recognize that their people have lives outside their job and want to enjoy the fruits of their labors. A lifestyle firm will tend to focus more on profitability so their owners can maximize their compensation and maintain their lifestyles. This culture can limit the firm’s available financial resources for a successful M&A effort.
A growth firm is just that – one focused on growth and reinvesting its profits back into the firm. This allows the firm to purchase new assets, hire new people, and make strategic growth investments. As the growth firm’s assets increase, they have additional collateral to finance debt obligations to facilitate further growth. Growth firms are particularly well suited for M&A opportunities.
- Cash and working capital requirements. The first question a firm might find themselves asking when considering M&A is, “Can we afford it?” or, “Do we have sufficient cash and capital to facilitate a transaction?” The answer to these questions largely depends on the answer to the following question – how much cash is on the balance sheet, in excess of what is comfortable to run operations? This is what we call working capital, and it is a vital component in calculating your firm’s purchase power. In short, working capital is the money available to meet your current short-term obligations, that allows you to be able to run your company smoothly. To sum it up, the cash available for a transaction is that in excess of your working capital.
- Closing costs. As you have probably imagined, the purchase price for a firm is not the only cost associated with a transaction. When closing on a transaction, there will be fees that can be similarly compared to the closing costs of buying a home. When closing on an acquisition, some of the fees you should consider are:
- Legal fees. Our best advice is not to focus on the hourly rate of a legal team ($200 to $800 per hour) and to focus much more on the transaction experience. You will need to focus on the legal fee estimate once you know the type of deal you are working on (asset vs. stock). These are typically the largest percentage of fees associated with closing costs, but a good legal team with AEC and transactional experience can make all the difference.
- Accounting fees. The biggest things that will impact on the budgeting for accounting fees is the capacity of your in-house accounting team, the type of transaction (stock vs. asset), and the complexities of the deal structure. The latest couple of transactions that Zweig Group has worked on were able to use almost exclusively in-house accounting plus minimal tax at the end.
- Tail liability insurance costs. This fee is commonly overlooked but is quite important for your firm. Tail liability insurance gives your business protection for claims in times of transition, such as a merger or acquisition. This is regularly a cost of three years of the average professional liability expense that the target has paid in the past. Normally this fee is split equally between the parties, though the seller will tell you the buyer always pays it (that’s not true, but such is the negotiation game!).
- The rule of thumb guidance toward these costs is between 5 percent and 20 percent of the total consideration for each transactional cost. It’s a wide range, but of course every deal is different. Figuring out the structure of the deal first is essential so you can get a better estimate of what these costs may be.
Deal structuring. There are many creative ways to structure a deal to offset the amount of cash due at closing and to incentivize both parties for mutual success and motivation. The typical rule of thumb when structuring a deal is 50 percent to 70 percent cash at closing of the total consideration (or purchase price) and the rest can be tied into a promissory note or an earn-out.
Promissory notes are typically a three-year installment of principal with an agreed interest rate (similarly to a money market fund rate) paid annually. This part of the deal structure is where you typically see the buyer take on debt to finance the acquisition, if necessary. An earn-out is a pricing structure where the target company must “earn/grow” part of their purchase price, based on performance of the business after the acquisition. Earn-outs provisions are usually employed to bridge a valuation gap between buyer and target.
The target receives additional consideration if it achieves certain business performance goals, such as future revenue and other financial metrics. Although, Zweig Group advises that earn-outs be tied to financial metrics that are higher on the income statement, such as top-line revenue or net service revenue, compared to net income or profitability. We advise on this so the target firm emphasizes their efforts on bringing in revenue rather than minimizing expenses which could include layoffs or the removal of bonuses for employees. These are just a few examples of how to structure a deal, but there are many other ways to do so to mitigate cash at closing and encourage a successful acquisition.
These are just a few topics of conversations and questions that I have had with AEC firm owners who have considered expanding through M&A. Zweig Group advises buyers every step of the way in a buy-side engagement, including helping them determine if an acquisition is feasible and if external expansion is the right avenue for them. If you have any questions or would like to have a conversation about the benefits that M&A can present for you and your firm, please feel free to reach out to Zweig Group’s M&A team for more information. We are always happy to connect.
Adrian De la Garza, CM&AA is an advisor with Zwieg Group’s M&A advisory team. Contact him at firstname.lastname@example.org.
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