How to Value an Architecture Firm
It is not uncommon for us to be engaged to provide our opinion on the fair market value of architecture firms. In this short piece, we look at some of the valuation issues that we typically encounter. While the metrics are different, the same valuation principles apply to other professional service firms such as engineers and environmental consultants.
Our experience is that most architects do not view their business as an asset that they might sell one day. There are good reasons for this. First, most architects work in small organizations that depend on their reputation, abilities and personal contacts for the inflow of work. Besides, given the expertise required to produce high-value design work, the ability to leverage less experienced staff is limited. Instead, the success of these smaller firms is generally related to the reputation of individual partners within engineering and construction firms, developers or government bodies.
Because there are few tangible assets in an architecture firm, the fair market value generally relates to cash flow the firm can generate in excess of a reasonable level of remuneration to its employees. This is where the concept of goodwill is important.
THE IMPORTANCE OF GOODWILL
The concept of goodwill is a good place to start a discussion related to the valuation of a professional service firm. Goodwill is the difference between the going concern value of the business and the sum of the value of the identifiable tangible and intangible assets. In simple terms, it can be viewed as the current financial value of expected future cash flows.
If the future cash flows of the firm relate solely to the skills and reputation of a person or persons, then the goodwill is personal and generally has no commercially transferrable value. An obvious case of personal goodwill is a scenario where all of a firm’s clients leave when a partner retires.
The reality for most architecture firms is that goodwill relates to a combination of the firm’s good name and client relationships, as well as the skills of the individual professionals working there. If these conditions exist and a partner leaves the organization, the customers will likely remain with the firm. This is an indication the goodwill is attributable to the firm itself and has commercial value.
EXAMPLES OF TYPICAL TRANSACTIONS
Owners of architecture businesses generally require a valuation in anticipation of a transaction. Examples include:
- Someone plans to join or leave the business and the shareholder or partnership agreement requires the ownership interest to be valued;
- Two firms are combining or merging, so each firm needs to be valued individually to allocate the proportionate ownership interests of the combining parties; or
- An ownership group is considering full divestiture and requires an understanding of the fair market value of the business before entertaining offers.
BUSINESS ENTERPRISE VALUE
While each situation is unique, a common approach is to calculate the value of the architecture business by capitalizing the normalized cash flow, before owners’ bonuses, using a rate of return that reflects current market conditions, as well as specific operating and risk factors unique to the business in question. This calculation can be reflected as a multiple of normalized EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) before owner bonuses. The resulting product is what we refer to as the Business Enterprise Value (BEV), which is the value of the business including the assets necessary to run it, such as capital assets and an adequate level of working capital.
A three-year study published by Rusk O’Brien Gido & Partners LLC (ROG Study) that focused on actual transactions can give us a better understanding of the market value of architecture firms. The study found that a clear majority of transactions involved the sale of non-controlling interest. A typical transaction would be the value of an ownership interest when a partner or shareholder enters or exits the business (Option A above). The median results as multiples of EBITDA and Service Revenue were as follows:
One would expect that the EBITDA and revenue multiples would yield a similar BEV unless there were extenuating circumstances (i.e. abnormal cost structure).
The ROG study also looked at transactions involving controlling interest acquisitions. The holder of a non-controlling interest in a business does not enjoy certain benefits that come with control. These include the ability to control the strategic direction of the business; determine the amount and timing of payment of bonuses or dividends; and the limited ability to sell their interest in the open market. The ROG study found that the BEV EBITDA multiple was approximately 1.0x higher for a controlling interest. In the case of architecture firms, the BEV would be calculated at approximately 4.24x EBITDA.
MARKETABILITY AND FAIR MARKET VALUE
Other factors impact both the marketability and fair market value of an architecture firm. These include the firm’s growth, relative efficiencies, and management ability. The ROG study looked at common professional service firm Key Performance Indicators (KPIs) in their sample group and found the mean results to be as follows:
It is often the case that the actual selling price of a business is different from the fair market value for a variety of reasons, including:
- Differing negotiating strengths of the buyer and seller;
- Differing levels of motivation to complete the transaction;
- Deal terms such as non-cash consideration or earn-outs; and
- Special purchaser premiums where a purchaser has strategic or other reasons to pay a higher price.
Regardless of the methodology used, all parties to a transaction should agree that the valuation is fair and objective. From there, the parties can work out terms of the deal including financing and the timing of payments.
Each group of partners or shareholders has a different set of circumstances that will influence their decision related to undertaking a change of ownership transaction. It has been our experience that succession concerns often drive the decision to do something. A professional opinion on the fair market value of your firm prepared by a Chartered Business Valuator is a good place to start. You might be surprised that your practice is worth more than you originally thought.
If you have any questions about this topic or others, please get in touch with one of our team members directly to learn how we might help.