The Connection Between Good Financial Management and Firm Valuation
July 22, 2020
While they can be performed at any time, it’s common for architecture and engineering (A/E) firms to have professional valuations done on their business at the start of their fiscal year. A firm’s principals look back at the last year and, especially if it was a particularly good or bad one from a financial perspective, they wonder how the firm’s performance has affected its value.
Often, they’re curious because they’re trying to decide if they should just dive into the new year the same way they have all prior years or if they should start formulating their exit strategy. And “How will I get my money out?” is closely followed by “How much money is in there?”
Obviously, the accuracy of the valuation is critical. And, we’ve found that certain conditions have to be present in order for a precise valuation to be developed.
Valuation Requirement #1: Good Financial Management
In order to get an accurate valuation, we’ve learned that an A/E firm must have an appreciation for, and willingness to do, effective financial management. This process can’t be treated like a necessary evil. It has to be embraced as a vital business function, just like it is in any other type of business that’s focused on profits. Yes, this can be a major leap for engineers and architects, most of whom have had little, if any, financial training. But it’s critical nevertheless.
It’s important to note that having a competent accountant on staff and an advanced financial management system like Factor AE is important, but it isn’t enough. What the firms we work with have told us is that principals must pay close attention to financial management throughout the year.
An approach where invoices are approved and timesheet information is entered when owners “get around to it,” for example, simply doesn’t support an accurate valuation. Nor does a lack of information on business processes like the pursuit of new business. Knowing how much was spent on the pursuit of a project vs. how much revenue the project brought in is key. ROI on these types of activities plays a significant role in a valuation.
As a demonstration of the gap between firms and valuators, principals will often ask a valuator what they need to do to get ready for the assessment, and of the 15-20 items suggested, the owner has only heard of 3-4 of them—profit and loss statement, balance sheet, bank statements, and tax returns for example. That doesn’t bode well!
"In order to get an accurate valuation, we’ve learned that an A/E firm must have an appreciation for, and willingness to do, effective financial management."
Valuation Requirement #2: Consistent Performance Tracking in Industry-Standard Form
Here’s where the right financial management package really pays off. A purpose-built tool like Factor AE can provide metrics unique to the A/E industry and absolutely necessary for a valuator to assess a firm’s potential. For example, most firms can tell you whether they’ve made a profit or not in any given year. But there are so many elements that can affect that number that by itself, it doesn’t provide much insight into the financial health of the firm.
The consistency piece is important as well. A valuator must be able to see trends in order to provide an accurate assessment of a firm’s value. Trend data can help them determine if the firm is good at making a profit or has just been the beneficiary of outside forces like the strong economy that the A/E industry has enjoyed for the past 11 years.
Some firms will say, “Our fees are competitive, we pay our employees fairly, and our overhead is similar to other firms like ours, and that’s why we make a profit.” But all it takes is a little digging under the surface by the valuator to find that there are complicating factors like a business model that’s unique to the owner and that makes the firm hard to sell. Consistent use of industry-standard measurements can help firms avoid disappointing revelations about their value.
Valuation Requirement #3: Valuator With Industry Expertise
In order to get an accurate valuation of your A/E firm, you have to work with a valuator who understands the industry. Only half of a valuation is based on the firm’s performance. The other half looks at the market they’re in, their fees relative to competitors, the strength of specific geographic locations, etc. CPA firms that don’t specialize in the A/E industry may consider things like GDP, national inflation rates, and the Federal Reserve Beige Book, but those are very surface-level numbers that don’t affect how a potential buyer looks at a 25-person engineering firm in Kansas City.
A true A/E industry expert does a deep dive into the firm’s market and clients, assesses the quantity and quality of the organization’s work backlog, and performs other analyses. If a firm focuses on transportation, what’s the outlook for that industry in their state? Is a healthcare-focused firm in trouble because it’s becoming clear that more hospitals have been built than there are patients to fill them? This kind of information results in a valuation that’s both meaningful and actionable.
For example, any valuator can come back and say, “To achieve the number you’re after, you need to charge higher fees, and your multiplier is too low,” but even that direction isn’t helpful without the sense of market dynamics and trends that an industry expert can provide. And, circling back to the idea of ROI on pursuits, if you’re tracking that information in an intentional way and start to feel like a particular market is “drying up,” the valuator’s market knowledge and research can help confirm (or refute) that belief.
Collaborating for the Most Accurate Number
Ultimately, the best assessment of an A/E firm’s value comes from the combination of a firm’s investment in good financial management, it’s attention to key metrics, and its collaboration with a valuator who is an industry expert. When those three elements are in place, the number generated in a valuation process is one that a firm’s principals can use with confidence as they form their strategy for the years ahead.
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