For architecture and engineering firms in New York, succession planning is often complicated by the state mandate that requires either 100% of the ownership to be held by licensed design professionals or more than 75% ownership if the firm has applied to be a design professional corporation. This not only limits the types of third-party buyers A&E companies can entertain, such as private equity firms, but also limits the internal candidate pool of buyers for an internal sale.
When considering your succession planning strategies in 2020, you need to look at the demographics. Baby boomers (55-75 year-olds) are typically the sellers of firms and Generation X’ers (40-54 year-olds) are typically the buyers. There are more than 20 million more baby boomers than Generation X’ers so it is safe to assume the potential internal buyer pool will include millennials (25-39 year-olds). Also, for the first time ever, millennials are expected to outnumber Baby boomers in the workforce this year.
This reality is shifting the ratio of buyers and sellers in the wrong direction. There will be more owners looking to sell than available buyers for the foreseeable future, as the second largest demographic in the workplace reaches retirement age.
With third-party buyers more difficult to find, and many owners not wanting to relinquish control to an external buyer for many other reasons, an internal sale may be the most attractive succession planning strategy for baby boomers and Gen X’ers alike. And that will most likely mean selling to millennials.
Preparing Millennials to Take Over Your Business
Gen X’ers who are planning for an internal sale have the benefit of more time to prepare their successors before reaching retirement age. But regardless of how close retirement is, this exit strategy should begin by looking at the workers who are under the age of 35 and providing the following opportunities to groom them and create more “buyers” for yourself:
- Leadership training
- Education on what it means to be a business owner
- Increased transparency into the business’s financial condition and vision for the future
Are Millennials Interested in Being the Successor?
As the adage goes, “you can lead a horse to water, but you can’t make him drink.” Despite your best efforts to woo this new generation into buying your business, is their famous avoidance of home ownership, as well as their well-known affinity to remain mobile, any indication that they won’t take the bait? And even if they are interested in owning a business, is it just as likely that these fiercely independent thinkers will want to work for themselves?
While broad generalizations about an entire segment of your workforce will never compare to intimate knowledge of your own workers and their unique goals and objectives, there are several strategies you can employ to make the decision to buy your business a more attractive one, such as:
- Entrance into new markets that will excite and engage the younger generation
- Exploration of sustainability projects that will invest younger workers more personally in the business’s success
- Participation in charitable initiatives that will involve this community-minded generation even further
Planning for the Internal Sale
When you have cleared the hurdle of identifying interested successors – millennial or otherwise – and decided to move forward with an internal sale, the next hurdle will be to determine how much capital the business needs to make it happen. Your internal buyers, especially ones who are earlier on in their careers, will not have the full amount of capital required to purchase the business outright. They will need to take on some level of debt and have the ability to meet their financing obligations.
In closely held A & E firms, some tough conversations may need to be had at this point with owners who have more shares than what they contribute to the firm. The best solution is for them to sell their interests to the level they are performing.
Transferring the Ownership
In an internal sale, the business owner(s) will need to decide on a method for transferring the ownership of the company. These options include:
- Direct buy from existing owners – Because this option requires “skin in the game” for new owners, be prepared to offer more money to them and/or have them take out a personal loan guaranteed by the existing partners.
- Employee Stock Ownership Plan – ESOPs provide employees with a financial interest in the company without any personal investment on their part. Being invested financially in a company is a powerful motivator for younger employees to stay long-term.
- Other advantages of an ESOP include creating a market for the shareholders, providing liquidity opportunities for existing shareholders and attracting new employees to the firm. Disadvantages include the risk of the ESOP being overvalued, as well as the burden on the firm to maintain enough cashflow to pay the debt it took on when ownership was transferred.
- Stock bonuses – If choosing this method, owners should consider the effects of dilution. Issuing more stock in the company will reduce the percentage of their own ownership and investment.
Valuing the Business
While there are many benefits to an internal sale, including maintaining the legacy of your brand and retaining your valued employees, you will most likely be selling at a discount. The first step to determining what that price tag will be is calculating your business’s fair market value (FMV), which is a multiple of earnings (some recent sales of firms have seen a 4-6 times multiple of cashflow). Discounts taken off the FMV typically account for a minority discount, lack of marketability and discount for initial buy-ins.
The second step is to determine the required capital (book value), which is what your internal sale price will be based on. A certified valuation specialist is your best resource for maximizing the sale price of your business.
When to Sell the Business
Especially in a closely held A & E firm, where multiple owners and their varying interests are involved, simple communication is where you should begin when deciding on the best timing for the internal sale. Ask the owners when they plan to retire and map out a timeline to understand how much capital will come out and when new capital will be needed. Also factor in the amount of time it will take to properly groom your successors to take over the business.
The silver lining to these challenges is that, unlike some other industries, the influx of millennials (i.e. potential successors) into the A&E industry remains strong. According to recent data provided by the Census Bureau, the number of civil engineering graduates in the U.S. workforce has been growing at a rate of 4.23%, with the Architecture & Engineering industry employing the greatest share of graduates.1
For companies based in New York, there could be additional good news coming in the form of legislation that would allow a qualifying ESOP to own more than 24.99% of the company while still preserving the current requirements that the firm’s controlling management positions be filled predominantly by licensed design professionals. This would open a whole new area of succession and tax savings strategies for A&E firms. A proposed bill is before the NYS legislature, and Grassi will keep you updated on its progress.
With the inevitability of your business exit and the many considerations that need to be made to transition out of it seamlessly, the key is enough preparation. Regardless of your stage in the business cycle, it is never too early to begin planning for the future of your business and its owners.