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Managing The Variables of Your A/E Firm Valuation
March 22, 2021
Carefully managing the value of your architecture or engineering (A/E) firm’s stock is important. Why? In order to have an effective ownership transition program, you must eliminate as much of the perception of risk as possible.
Architects and engineers are risk-averse people by nature. So, if you invite them to invest in the firm, they may ask, “How likely is it that a ‘worst case scenario’ will occur and I’ll lose all my money?”
To answer that question, you have to show them information on the firm’s performance through the years. Unfortunately, if the firm’s up and down profits (as caused by normal industry ebbs and flows) are mirrored in the stock price, people will probably look closely at the down years and dismiss the up years as anomalies. However, there are steps you can take to provide an entirely accurate, but more appealing, financial profile.
Year-End Financial Management is Crucial
At the end of each fiscal year, your firm’s board of directors has to manage the financial picture with valuation in mind. Nobody ever forgets to manage the year-end picture from a tax perspective, because the guiding principle is simple: the less tax you can legally pay, the better.
You drive down your taxable income any way you can. The problem is that lowering your taxable income affects the firm’s valuation in terms of internal sale of stock among shareholders. So, the components of managing taxes and managing the firm’s value are very similar.
In order to find the right balance, the first thing your firm has to do is reach consensus on the definition of “profit.” There are many ways to lump additional expenses in with the firm’s standard expenses to lower profit. You can also lower salaries in order to take more profit out of the firm at the end of the year.
In short, there are as many approaches to calculating profit. There’s no right or wrong way to look at it. The key is that every stakeholder has to understand how profit is arrived at, and that process has to take place the same way every time.
Accrual Accounting and Firm Valuation
Most firms look at incremental cash received in a fiscal year as their taxable income. And because they file their taxes on a cash basis, they want to lower that number.
However, in most cases, the proper definition of profit begins with accrual accounting. You have to use accrual accounting to align the cash coming into the business with the costs going out of the business in the same time period.
But accrual accounting is really just “table stakes.” If you don’t use this system, you’ll have a mess on your hands. The result is that most firms must essentially keep two sets of books: cash-basis accounting for taxes, and accrual-basis accounting for profitability and firm valuation.
After settling on a definition of profit, you have to develop a formula for calculating the value of your firm. Profit is typically a part of the formula, but it’s not the only component. Many firms include some element of book value, which is also called shareholder equity. We recommend this to the people we work with, since A/E firms typically are not great at collecting outstanding debts and accounts receivable (AR) is often a significant figure that isn’t captured in profit.
Another part of the equation is how your firm deals with debt. For example, if you’ve bought out some shareholders but still owe them money, do you count all of that debt (regardless of when it comes due) against the firm’s valuation? Or do you look at it from the perspective of what will be paid in the next year and before the next valuation?
Either way is valid, but again, consistency is vital. You have to know why you do things the way you do, stick with that approach, and avoid the temptation to modify it to meet a particular need. Of course, ultimately what matters is that stock buyers and sellers agree that the asking price is fair. The actual dollar amount isn’t especially important. You just have to minimize what’s called the “beta” or the variability between high and low share prices.
"We've found that too many firms believe a change in valuation is something that happens to them rather tahn something they can control and manage."
Valuation: Understanding That It Doesn’t “Happen to You”
At the end of a fiscal year, many firms look to recalculate their value. We’ve found that too many of them believe a change in valuation is something that happens to them rather than something they control and manage.
If the value arrived at is surprisingly high or low, the hard (but helpful) truth is a firm has nobody to blame but itself. That’s true because all the variables mentioned above (definition of profit, use of accrual accounting, balance sheet additions) are within the firm’s control.
It’s also important to note that the line item for year-end bonuses paid to employees versus distribution to shareholders must be flexible. You can push more or less profit to the bottom line for valuation purposes based on whether you define money going out as an expense or a distribution. Distributions are after profit has been declared, whereas bonuses reduce profit.
And while there may be bonus expectations based on the type of year you had, the amounts can’t be decided in a vacuum. You’ve got to consider how they affect valuation.
A Closer Look at Book Value
In calculating your firm’s value, you have to be careful and consistent in how you include accounts receivable. Specifically, receivables on invoices you just sent out are likely to be collected. Outstanding AR from long ago probably isn’t. What kind of allowance do you build into your calculation for the time value of money? (Money in your pocket today is worth more than money you might receive down the road.) And what receivables should you just write off?
Any adjustments you make throughout the year should be on a project-by-project basis, and that process should be relatively easy to manage. If you keep your finger on the pulse of your projects, you can maintain a pretty good idea of what money will be coming in and when.
Some firms will simply include a percentage of AR in their valuation. But even a percentage of an unreasonably high number is a large figure, and probably doesn’t support proper valuation. So, we advise caution here.
Mastering the Variables
In our experience, roughly 70% of the factors a firm might use in its valuation process are under its control. Firms that don’t understand and manage these variables will struggle when it comes to determining stock value fairly and consistently.
And, again, we’re talking about managing stock value, not manipulating it. But if you master the financial “levers” at your disposal, and can deliver a steadily increasing figure year to year, all of your stakeholders win.
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