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Challenges

Privately owned firms are the rule in the architecture sector, with thousands of such firms. No matter how young or old, how large or small or how diversified or specialized, each firm faces a competitive environment that continues to consolidate. In recent years there has been an increasing and sustained pace of mergers and acquisitions rivaling the heights of 2007. It appears that there is continued confidence on the part of institutional investors and savvy buyers who see the industry fundamentals as stabilizing and long-term trends as encouraging. Some industry consulting and financial advisory firms which track such activity believe that the continuing needs of baby-boomer owners to free up their investments in their firms and the increasingly competitive environment will result in many firms seeking or accepting an unsolicited external exit.[1] With both buyers and sellers seeking transactions, it may be that we will see a continued vibrant pace.[2]

Privately owned firms of all sizes must transition ownership and leadership each generation if they wish to sustain themselves as independent entities. Internal ownership transitions, which have historically been the preferred method of intergenerational transfer within a firm, have become more difficult to consummate successfully given the uneven financial performances of many firms in recent years. Virtually all internal transitions are funded, in whole or in part, by bonuses and distributions from the firm. The performances of architecture firms from 2008 to 2011 have negatively impacted the amounts which can be bonused to younger owners to finance their purchase of shares and leadership succession and ownership transition was delayed. The market began a turnaround beginning in 2012 and continued strong performance will increase the likelihood of successful internal transition. Without such an infusion of profits, firms often find it impossible to finance the redemption of shares by older leaders and still allow the firm to have adequate capital to operate and grow. The second part of the challenge is the absence of the next generation of architects, who while talented professionals, do not necessarily have the inclination or entrepreneurial business instincts to lead a firm.

A recent article sets forth the alarm regarding a firm's ability to redeem shares based on an analysis of the growing number of baby boomers over the next two decades.[3] The rate of change in population demographics will have a significant effect on value, liquidity and leadership succession. Over the next two decades, the population of those 65 to 84 years of age will increase by nearly 30 million people while the population of those 25 to 64 years of age will increase by a little over 11 million or nearly one-third as many as those reaching retirement, resulting in an abundance of sellers and a shortage of buyers. The concern is that the need to devote future cash flows for share redemptions may impact the ability to grow, pay competitive incentive compensation to staff and generate a return for owners. The chart below is a graphic illustration of these statistics.

Clearly, firms who wish to pursue an internal intergenerational transition will find that it is not without its challenges. More and more firms are incorporating ownership transition in their strategic planning engagements to address slow growth rates, lower profit margins, the demographics described above and obligations to previously separated shareholders in an attempt to formulate a realistic internal ownership transition program.[4]

Firm Size

Firm size categorization, for purposes of this paper, is as follows:

Number of Employees Size
1 to 20 Small
21 to 100 Medium
101 to 450 Large
451+ Extra Large

Mid-Size, Large and Extra Large Firms

Large and Extra Large independent firms face profitability challenges from larger, well capitalized publicly-held firms which may bid aggressively for work to keep their staff busy and from smaller firms which may undercut their pricing due to lower overhead and efficiencies in operations. Industry specialized valuation and financial advisory firms have been discussing the so-called vanishing mid-sized firm, characterizing such firms as to be too large to be small and too small to be large. However, a recent study argues that the midsize A/E firm is not dead or dying, but rather sustaining itself.[5] Medium size firms often have solid profit, top partner salaries and top design award recognition. However, after the current generation of leadership it may be difficult to sustain such financial and design levels without an external transition as the internal talent may not measure up as leaders. With the right leadership, however, a medium size firm can attract clients and talent and it is a great size to practice architecture.

The factors that lead a firm to seek an external transaction are several:

  1. Higher Valuations External valuations are almost always higher than internal transition valuations, are paid more quickly and with less risk of nonpayment. Valuations of external sales are often based on a multiple of historical earnings and are appreciably higher than the book value of the firm. The multiple of earnings a buyer is willing to pay is generally higher for large and extra large firms than small and mid-size firms, since so few firms are so large. Brian Kenet, a Consulting Principal at EFCG, based on his experiences in advising in several of the largest architecture mergers and acquisitions, believes that buyers are willing to pay a higher multiple for larger firms since such firms are governed and operate in a corporate-like organizational structure not dependent on a small group of principals to generate project work. Valuations for internal sales are typically at book value or book value plus perhaps a small premium, but always lower than an external sale. The valuation in the case of a firm closure and liquidation is never more than the book value of the firm at the time of its closure and is almost always less since monetizing the balance sheet inevitably results in some slippage in collecting accounts receivable.
  2. Ownership Transition Failure Many firms are burdened with a disproportionate number of older owners/leaders who own a majority or significant portion of the firm and/or with obligations owing previously departed owners. There is a shortage of younger professionals who are prepared and inclined to take over the ownership of a firm, particularly when firms have not been able in recent years to generate strong profits to bonus younger owners to allow them to finance the purchase of shares. The demographic statistics, as previously discussed, indicate that the challenge of an internal transition is likely to become more acute in the future.
  3. Leadership Succession Failure Most firms have not adequately prepared the next generation to take over the management helm of firms, and in many cases there are not members of the next generation of management who wish or are inclined to take leadership positions.
  4. Client Demands Many clients are demanding that firms have increasingly broader service platforms and geographical reach to minimize the number of joint ventures, firms and subconsultants on each project. Mid-size, large firms and extra-large firms either do not have the resources and capital or the inclination to spend such resources and capital to face consolidating competition and growth pressures , either organically or through acquisitions.
  5. Diminishing Financial Performance Firms must contend with increasing corporate overhead and fixed costs, the need for more astute business management and larger competitors who are chasing smaller projects, which may result in lower profitability and tighter financial constraints.
  6. Ongoing Employment External transactions virtually always include continued employment for firm owners and staff and ongoing servicing of firm clients, which allows for a perpetuation of the firm or components of the firm in a larger context.

Small-Size Firms

Firms below the mid-size level may prosper with lower overhead, nimbleness in operation and may focus on one discipline, market segment or geographic area. Often, such firms are owner/founder centric, with leaders attracting the firm's projects because of individual reputations since the firm is not viewed as an institution. Clearly, these firms are more likely to have an unsuccessful ownership transition and management succession program since there are far fewer candidates in the next generation to own and lead the firm and the spector of succeeding the owner/founder may be extremely difficult. For smaller firms, they must either find a buyer who is looking for a so-called "niche" or "tuck-in" acquisition or face the prospect of closing the firm since there is no realistic way to perpetuate the existence of the firm through internal transition. The same factors which apply to larger firms to seek an external exit are equally applicable to a small firm, and in some cases, even more applicable.

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