The Lowdown on Buying or Selling an Engineering Firm (in Austin, Texas and Beyond) – Part 1
During the past nine months (2016-2017), I represented four sellers of engineering firms based in Austin, Texas. My role has been as their M&A attorney. In three cases, the seller sold to a much larger engineering firm. In one deal, the seller sold to a private equity group that bought a larger engineering firm a few years back and is using that first purchase as a platform for future acquisitions. It’s interesting this is quickly becoming a cottage industry for me. One owner of one of the selling firms told me the information on my site resonated with him because I approach and look at the world like an engineer. I never heard that before, although I appreciated (what I took to be) the compliment.
In this article, I lay out some things buyers and sellers of engineering firms should consider when getting into the M&A (mergers and acquisitions) game. I also provide general information about engineering firms and the industry to help other advisors – M&A lawyers, investment bankers and appraisers who are working with engineering firms in the merger and acquisition process.
Overview of the Engineering Industry in the United States
Before diving into the mechanics of the M&A process for engineering firms located in Austin, it is important to get an understanding of the industry. Those who work in or with the engineering industry know that most engineering companies are small, privately owned, professional service businesses with less than 25 employees. In fact, fewer than 8% of U.S. engineering firms that fall under SIC code 8711 and NAICS 54133 (the industry code for most engineering ventures) have more than 25 employees.
Despite their small size, these firms can generate sizeable annual revenues, with the average engineering company bringing in approximately $3.5M each year. Revenue per employee for engineering firms hovers around $211,000, but that is just an average. Your firm or the firm you want to buy may have much higher or lower revenue per employee. This depends a lot on the type of service being offered and the typical client. It also may depend on how well run the firm is. You’ll need to dig deeper to figure out exactly what a different number signals (is it strong vs. weak management or a function of the particular target activities and clients).
While the top 4 engineering firms account for about 15% of the engineering consulting industry’s $208B in annual revenue, smaller firms must distinguish themselves through several factors. Perhaps the most significant factor is their ability to be highly specialized in a specific engineering discipline or sub-discipline. Some of the broader engineering disciplines include the following:
- Electrical engineers
- Mechanical engineers
- Industrial automation engineers
- Civil engineers
- Structural engineers
- Environmental engineers
- Chemical engineering consultants
- Information technology services engineers and IT systems engineers
Most engineering consulting (NOTE: engineering firms often describe themselves as engineering consultants because much of their work is advice-related, not merely construction or implementation – there is usually a high degree of design and advice) companies providing services related to these broader disciplines are locally owned and operated. Whether they are in Austin, Houston, Dallas, San Antonio, or anywhere else in Texas (or elsewhere in the U.S. for that matter), these smaller firms tend to find their niches in their target geographies and differentiate themselves in a manner that makes them attractive to potential buyers. And being locally owned and operated is a plus given the extensive licensing requirements for the industry.
So, whether you are looking to acquire, sell or merge an existing engineering firm, a key way for determining the business value of a firm turns on how it differentiates itself from the competition. Earnings alone may not provide enough insight to properly value the business. Earnings are historical-looking, whereas strong differentiation can be forward-looking if it signals a strong market position and long-term pricing power. Ultimately, earnings are critical, although don’t overlook the fact that they may not tell everything and a firm that has taken the time to carve out a strong market position may be poised for outsized growth going forward and some of that may not yet be reflected in the earnings history. If you’re selling your engineering firm, you want to make the argument to the buyer that the future is particularly rosy based on the work you have done to-date to position the company for the future and that’s all about differentiation and competitive positioning.
The Role of Professionals in the M&A Process
When selling or acquiring an engineering firm, there are several different professionals you are likely to encounter. In the engineering industry, we hear about mergers and acquisitions of small-medium firms with large firms quite often. However, just because you might be the “little person” in a particular transaction does not mean you’ll have a bad transaction team. Instead, you want to assemble a team of professionals who will help you maximize your goals for the transaction. Each professional has a unique role in the M&A process and can be a key ally for you. What follows is a brief overview of each one of these players and the role they play in the M&A process.
Business Brokers / Investment Bankers
Business Brokers: Business brokers (also called business transfer agents or intermediaries) assist buyers and sellers in the buying and selling of their privately held small engineering firms. They generally work on transactions in the $2M and under range – for the so-called “main street”-type business. Business brokers handle a variety of tasks, which can be grouped into the following three major categories:
- Preparation for a sale
- Marketing the business
- Closing a deal
Business brokers may work for a monthly fee, although they generally provide their services in the same manner as a commercial real estate agent – on a full-service and contingent basis, whereby their full commission is earned if and when your deal closes. The broker services vary widely depending on the interests and skill set of the broker and what you hire the broker to do.
The key is finding someone who will be your ally during the course of the transaction – a broker for whom your transaction is exciting and represents a nice commission for them, but is also within their sweet spot. In other words, you don’t hire Goldman Sachs (a tier-one investment bank) to sell a $2 million company. Even if they’d do it (and don’t worry, they won’t!), they wouldn’t put much effort into it. Goldman Sachs represents $2 billion companies. A commission on a $2 million deal would not be worth much thought (nice to be them!). On the other hand, you don’t want to hire a business broker that generally sells $400K businesses if you have a $10MM company. There is a saying in the mergers and acquisitions world that small and large deals are the same, except for the number of digits to the left of the decimal point. While there is some truth to this saying, it’s not entirely right. You want professionals, including a broker, that are comfortable with companies of a certain value. The nuances of the negotiations will vary by transaction size and the parties in the deal are different in terms of style and sophistication, depending on the size of the business being sold.
Depending on the valuation of your Texas engineering consulting firm, you may need a business broker for your transaction. If the valuation is higher, then an M&A advisor or investment banker may be a better fit.
M&A Advisors and Investment Bankers: M&A advisors and investment bankers, like business brokers, are intermediaries who help you either acquire or sell a company. They typically get involved in the lower middle market (companies that sell for between $2M to $50M) and upwards from there. In addition to providing strategic advice on the M&A process, investment bankers are often involved in raising capital and selling securities. They usually have licenses to deal in securities, whereas as business brokers typically do not. So, if you plan to sell stock (equity) in your privately held engineering company, then an investment banker is probably a better fit.
Two great reasons for involving an investment banker or M&A advisor is to seal the deal and to maximize the terms of the deal. The sale of an engineering firm in Austin or Texas generally can sometimes be a difficult procedure for both sides of the deal, so what could be more beneficial to the entire process than having a talented, highly experienced third-party negotiator working for you to keep discussions from being too clouded by the differing perspectives of either party? Great deal makers help get deals done on terms that are good for their clients. They understand navigating emotions and preserving relationships, while also maximizing value to their client. They also shepherd the process and ensure that the transition is made as smooth and legally sound as possible.
A critical player on your deal team will be your lawyer. The lawyer you engage will work directly for you (or your engineering company), as opposed to working as a neutral intermediary. All lawyers owe their clients fiduciary duties, which means that your lawyer will have your best interests in mind.
M&A lawyers provide a variety of services, including preparing non-disclosure agreements (NDAs) or confidentiality agreements and preparing purchase and sale agreements, seller-financing promissory notes and helping with due diligence. Employment and tax considerations also generally fall to the lawyers, although sometimes a CPA is needed.
By far, the most important consideration in choosing a lawyer is that they have plenty of knowledge and experience with mergers and acquisitions generally. It helps if they have experience in your industry – with mergers and acquisitions involving engineering firms or engineering companies. When it comes to M&A, different industries have specific nuances that only an experienced corporate attorney can help avoid or address. For the engineering industry, states have rules for licensing, corporate structures and oftentimes require specific forms. Your corporate attorney can help guide you when it comes to these nuances.
Besides having a lot of M&A experience, an important thing you should look for is a lawyer you like and who will work the way you want to work. This is your deal. The lawyer is there to help you make it happen while also keeping an eye out for and addressing issues that could undermine your deal goals. So, it is important to find a business attorney who has your back and talks language that makes sense to you. There is no one way to lawyer a business sale or acquisition. How your lawyer works (what they do) is a function of your budget, your appetite for risk and your ability to handle things in-house with internal people. These are things a strong corporate attorney will discuss with you in determining what to do and how to properly approach and budget the legal fees for your deal.
The price you can expect to receive for your engineering firm or engineering company will likely play an important role in your decision if and when to sell. However, determining a reasonable expectation regarding sale price is not a simple exercise.
What matters most is finding an objective measure of fair market value for your engineering firm. Calculating the fair market value is something you will likely want help with, so you should find a professional business appraiser to perform the calculations.
A qualified business appraiser may use any number of methods to evaluate your business – from discounted cash flow analysis to comparable company analysis to precedent transaction analysis. But you need to know that valuation is more art than science. Don’t leave money on the table by choosing financial advisors that lack deep knowledge of the engineering consulting industry. Anyone can run a database search, but true professionals will be invaluable in helping you select the right price at which to sell your Texas engineering firm or engineering company.
Note that business brokers and investment bankers will value your firm. So, it may not be necessary to hire an appraiser if you know you are going to hire a broker or banker and go down the path of selling your firm. Or, a broker or banker may provide an estimation of value as a complementary service to build a relationship. Sometimes, though, it’s simpler to engage an appraiser at the start to figure out if it makes sense to go further.
Accountants are invaluable during the M&A process. They help bridge the gap between fair market value and financial data presented under GAAP. Accountants can help you identify tax and accounting issues, which drive many deals and can directly impact the purchase price (decisions such as whether to sell the assets of your business or the stock/equity of it are key decisions to make at the start), while also helping deal with those issues that might crop up. If a valuation assumption is wrong or if the transaction structure would take away from the price you pay or receive for the deal, your deal team’s accountant can spot those issues and try to resolve them.
Accountants can provide services vital for selling your engineering firm or engineering company, and you should certainly include at least one accountant on your deal team. When buying a company, accountants help determine the quantity and quality of earnings, the quality of assets and liabilities, conduct due diligence, handle tax matters or considerations, determine your working capital and cash flow, among other services. In sum, you will want a good accountant as part of your deal team.
Selling a privately held engineering firm in Austin, Houston or elsewhere in Texas is a significant decision, so make sure your deal team works for you. Every issue, no matter how technical or complex, can be boiled down to something you can understand and make a decision about. You want counselors and advisors around you who adapt to your needs and expectations.
Key Operating Metrics for Engineering Firms
Generally speaking, your goal as the seller of an engineering consulting company is to make your business as profitable as possible, which makes your engineering firm a ripe target for prospective buyers. Buyers prioritize profitable businesses. Whether you’re buying or selling an engineering firm, there are five key metrics that you will want to look at to gauge the performance and profitability of each engineering consulting firm’s business model. So, before jumping into the M&A process, sellers of engineering firms need to make sure that they have processes in place to collect information on these metrics and address any issues that might negatively impact profitability.
Those metrics are:
- Utilization rate
- Billing multiple
- Breakeven multiple
- Working capital
- Net Income Per Employee (NIPE)
Let’s walk through each of these metrics so you, as the buyer or seller of an engineering firm, have a good understanding of what to expect and how to evaluate each metric as part of the M&A process.
Utilization rate is the percentage of hours employees work that is charged to clients. The utilization rate measures both how busy employees are and their capacity to take on additional projects or assignments. Both buyer and seller should be looking for a target utilization rate of 65-67%, although firm principals (who spend the bulk of their time on business development) should generally have a target utilization rate of 50%. Anything below these levels means there may be problems with profitability or, in some cases, process or other flaws preventing the engineering firm from reaching optimal utilization.
Next, there is the billing multiple, which is how much the firm bills compared to its labor costs. Before the financial crisis of 2007-08, engineering consulting firms had an average billing multiple of 3.0, but certain firms may not have reached that old standard – especially those working in industries that are in down periods, such as engineering firms working with oil and gas companies in Texas, which until recently were significantly impacted by the low price of oil and natural gas.
Given that a billing multiple of 3.0 is the target, you should evaluate the billing multiple on several different levels, starting with individual projects and expanding upward to the entire firm. This gives both buyers and sellers a better understanding of how the engineering firm is doing and how it handles the workflow. Many engineering firms have a much higher multiple at the start of a long-term project, but that multiple decreases as deadlines shift and project scope creeps.
Relatedly, the breakeven multiple shows the minimum amount of money the engineering firm must make to cover its labor costs. The breakeven multiple, which should be less than 2.7, reveals the engineering consulting company’s profit when compared against the billing multiple.
Working capital shows how much liquidity the engineering firm has. Working capital is current assets (accounts receivable, cash, marketable securities and inventory (many engineering firms have little to no inventory)) minus current liabilities (accounts payable and short-term loans). When looking at working capital, you’re essentially asking if the engineering consulting company can pay its bills. Positive working capital is important, especially in the long term, but engineering firms sometimes run on thin working capital or negative working capital. In these situations, the engineering company may not have as much advantage in a merger or acquisition.
The final metric you should evaluate on a regular basis as the seller and, for buyers, during the M&A process, is the net income per employee (NIPE). NIPE is calculated by dividing the engineering firm’s net income by the number of employees. If the NIPE is high, then the engineering company is efficiently using its employees. NIPE for engineering firms hovers around $211,000.
If you are interested in selling your engineering consulting firm or merging with another company, then you will want to monitor these five key metrics over time so you can make improvements. Potential buyers are also going to want to see historical data on these five key metrics when evaluating an acquisition or merger. So, keep these key metrics for engineering firms in mind as you enter the M&A process or consider entering it as part of your exit strategy.
The Lowdown on Buying or Selling an Engineering Firm (in Austin, Texas and Beyond) – Part 2
What is an Engineering Firm Worth?
So, the big question: what is your engineering firm worth (or, if you are looking to acquire a business, what should you pay for it)? Luckily, valuation is something each of us does every day. Whenever you purchase a new company vehicle or acquire new software vital for your engineering company, you have valued the product and determined it was worth the price paid. When it comes to mergers and acquisitions of engineering companies or engineering firms, there is more that goes into the equation, but the core principle still holds. This is something you as an engineering company or engineering firm owner will want to know – whether you are looking to retire, trying to move on to the next big thing or just looking for a change of scenery.
Before addressing valuation in general, it is important to understand the difference between public and private companies. When you sell a share of stock in, for example, Schlumberger Ltd., Halliburton, or National Oilwell Varco on the New York Stock Exchange, there is a market for that share that determines the price. Whether that price is $15 or $100, you know what the share is valued at. In contrast, there is no NYSE or equivalent for shares of stock in privately held engineering companies or engineering firms. In a sense, there is no “market” that sets the price for each share or, in some cases, the assets of the engineering firm. So, it can be much more difficult to figure out the value for private companies.
That’s where professional business appraisers come in handy. Valuators can step in and determine that value for you based on information about your company, information about the engineering industry, and their own professional business judgment and experience. So, let’s unpack their process.
First, the most complicated aspect of valuing an engineering company in Austin, Houston or in Texas generally is determining the value of the human capital and other intangible elements. Engineering firms, generally speaking, tend to have more “human capital and other intangibles than, for example, an oilfield services company, so your bottom line valuation is going to be based in large part on your people and relationships. Beyond that, there are several other characteristics of engineering firms that should be factored into the valuation:
- The licenses held by employees at your engineering firm as well as any other professional certifications or courses of study completed;
- The trust between employees and managements as well as the owners; and
- The relatively small amount of fixed assets owned by the firm.
Second, it is important to have a good understanding of the basic standards of valuation. I have previously used the term fair market value, but what is fair market value? Well, fair market value is the most common standard of valuation. It can be defined multiple ways, but the U.S. Treasury Department defines it as follows: “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Did that clear things up? I didn’t think so.
So, let’s add some color to this fair market value definition. In 1959, the Internal Revenue Service published a ruling that establishes guidelines for determining the value of stock in a privately held corporation. While not a statute, this IRS ruling has nevertheless survived for more than 50 years. The key points of this ruling are:
- Valuations are just prophecies about the future based on all available facts as of the date of the appraisal. Valuations do not guarantee outcomes or performance.
- Custom valuations are worth much more than formula approaches to determining value.
- Remember that business valuation is an art, not a science, and a lot more than what can be shown on a spreadsheet goes into the calculation. Common sense, professional judgment, reasonableness and allocation of risk all factor into the valuation equation.
- The fair market value of your engineering firm or a firm you hope to buy will change over time. In an economic recession, for example, you would typically get or pay less for the firm. For more on this issue, read http://www.businessattorneyinaustin.com/2016/09/importance-of-timing-when-selling-business/.
- Professional appraisers (and brokers and bankers) are not always right, and more often than not will disagree on the exact value of the company. Ultimately, you must trust the approach and methodology of the people you engage to determine value, but you must open to understanding when the party on the other side of the deal argues for a different number.
While the “art, not a science” mantra still applies, the IRS has provided some information that may help improve the “science” side of the valuation equation. Factors to consider when valuing an engineering company include the following:
- Nature and History of the Engineering Firm: This factor is key to any valuation equation. For one, the history of the firm shows stability over time, growth, diversity of operations and more – all of which are essential to forming an opinion of the risk of buying that engineering firm or selling that engineering firm.
- Management Team and Personnel Generally: One major factor in valuing engineering consulting firms is the depth and experience of the management team as well as the trained personnel – all of whom could affect the value of the business. As I mentioned earlier in this article, engineering firms generally do not have many tangible assets, so their value is oftentimes locked up in personnel, management and other intangibles like goodwill and client relations.
- Economic Outlook Generally and for Engineering Consulting Industry: Starting broadly, the general economic conditions of the U.S., as well as your local market (Texas and Austin) all impact the value of the firm, but buyers will also look at the conditions of the engineering consulting industry in determining the price.
- Book Value and Financial Condition: Every valuation will involve the engineering firm’s balance sheet and related financial statements to spot issues like liquidity, the “quality” of the fixed assets, working capital and long-term indebtedness, and the capital structure of the firm. An appraiser will pay particular attention to anything that might affect the fair market value of the company.
- Earnings Capacity: To determine earnings capacity for the engineering company or engineering firm, a buyer will examine the income statement for the current period and for at least five prior years. Depending on the age of the business, some valuators even ask for income statements going back more than a decade to see how the engineering consulting firm has handled good and bad economic times.
- Sales and Size of the Block of the Stock. If you are selling stock or buying stock in an engineering consulting services firm, then there are a whole host of additional considerations to be factored into the value you receive or pay. If a buyer is acquiring a minority interest in your company (basically, making an investment in your company rather than an outright purchase of), for example, then the value will typically be less. The premium a buyer pays for full control of the acquired company is called the “control premium.” If the buyer does not get any say in the operations of the company (i.e., because the buyer only buys a small stake and doesn’t have the ability to control decisions), then the buyer will more than likely aim to pay even less for the stock.
- Comparison to Other Firms: Ultimately, the sellers want to make sure you get a comparable amount to what someone in similar circumstances got for a different (but similar) transaction. The buyer, of course, wants to be sure to not overpay. So, both sides have an interest in knowing what happened in similar transactions involving engineering consulting companies in the local market. Data points from similar sales are called comparables. Business brokers and investment bankers who have sold similar companies will have these data points. So may your deal attorney or other advisors.
These factors, along with several more, form the bedrock of any engineering firm valuation. Some are weighted more heavily than others based on the transaction, and each individual transaction may have its own unique aspect that enhances or minimizes the relative importance of certain factors. The bottom line here is that you, as the buyer or seller of an engineering firm or engineering company, need to have professionals doing their job to provide you with an objective measure of the value of your company or the target company.
I know you’re looking for more concrete data. While an oversimplification, in the interest of giving you something more tangible, it’s not uncommon to see small engineering firms sell for 3 to 5 times seller discretionary earnings, which is a measure of earnings that considers the compensation of the seller (the owners) and unnecessary expenses. For a quickly growing firm with strong market position, expect to pay (or receive) more. For a stagnant firm with revenues of less than $2MM (across industries it’s common to see sale price multiples increase as revenues grow because higher revenues generally reflect a business that is more systematized and less dependent on its owner, plus there is more activity (e.g., more bidders) as transaction values increase), multiples may be a little less.
The Due Diligence Process During M&A
Due diligence is a term in M&A for looking under the hood and kicking the tires of the company you are thinking about purchasing. Typically, due diligence involves the request for and review of the legal documents of a business as well as documents related to finances, operations and IT systems. Why do you want to conduct due diligence? Due diligence helps the buyer decide if purchasing the target engineering firm is a sound commercial investment. We generally think of due diligence as a buyer activity, although for the seller, due diligence can confirm that the buyer is serious about the transaction and can afford to pay for your engineering firm.
While deals sometimes fall apart because of information gathered during the due diligence process, more often than not the parties use the gathered information to shift risk back and forth. For example, you might decrease the purchase price of the engineering firm if due diligence reveals a pending lawsuit or some other large issue that the buyer would have to deal with post-closing. Or, as a buyer you might seek stronger representations and warranties and indemnification provisions in the purchase agreement.
Now, both sides are likely going to be concerned about confidentiality. From the seller perspective, you would not want to reveal all your major contracts, for example, to just anyone. From the buyer perspective, you may not want other engineering firms, competitors or the public to learn about the details of the merger or acquisition. So, both parties should be willing to enter into a confidentiality agreement — also known as a non-disclosure agreement — before investing all the time and effort it takes to conduct due diligence. If you are the seller and the buyer gives you a confidentiality agreement, it is time to call your M&A lawyer. Once you’ve got that confidentiality agreement down, then it is time to dive into the due diligence process.
Two additional considerations should be top of mind as you enter the due diligence process: (1) the scope and (2) organization. Both are vital and can help or hinder finalizing the transaction, so you want to make sure your team is on top of both the scope and organization of the due diligence. For the scope element, factors like the deal structure, cost, access to each other’s businesses, and time constraints can all expand or reduce the scope of the due diligence process. For the organization element, it is critical that you have someone on both sides working to organize the due diligence process. Having a smooth, organized plan in place can save a lot of time, effort and stress. The due diligence plan should include things like the scope of due diligence, tasks and assignments, budgets, deadlines, threshold issues, communications process and more. The bottom line is that you need a plan in place before entering the due diligence process.
Once you have that due diligence plan, it’s time to dive in. Starting from the buyer’s perspective, let’s walk through what exactly the buyer will be looking for in the due diligence process. This depends, of course, on the specifics of each purchase of an engineering company, but there some key questions that every buyer will ask:
- Does the seller of the engineering firm have good title to the firm’s stock or assets (depending on which is being purchased)?
- Does the value of the engineering firm make sense based on the available financial documents?
- What liabilities and risks are outstanding and how will they affect the purchase price?
- Are there any barriers that might delay or prevent this transaction from taking place and, if so, how should they be handled?
- What are the operations of the engineering firm?
- What actions will the buyer have to take to integrate the engineering firm or assets of the engineering firm into our existing processes?
- Does this merger or acquisition require any additional documents?
To answer these fundamental questions, the prospective buyer of an engineering company will send over what is known as a due diligence request list, which is an organized list of questions and requests for documents. The buyer will oftentimes send additional due diligence request lists over time, which is why it is important to make sure the due diligence scope doesn’t expand and become too much of a burden. Experienced M&A advisors, such as investment bankers and merger & acquisition attorneys, can help facilitate the due diligence process, making sure it moves smoothly and relatively quickly.
With the due diligence request list, the buyer typically asks for documents like corporate records, contracts and financial reports, but the buyer may also rely on publicly available information (if it is out there). As the seller of an engineering firm, you may also need to make your senior management team available for an on-site visit and to answer buyer questions.
If you are the seller of an engineering firm or engineering company, then you will likely need to conduct your own due diligence of your firm and the prospective buyer in the lead up to and as part of a merger or acquisition. Due diligence can be expensive and time-consuming, so you want to get your documents organized before getting too far into the merger or acquisition process. This helps everyone with the negotiations and drafting process. You also want to look for any liabilities or issues that might devalue your engineering firm to see which ones could be remedied.
You also need to look at the buyer to make sure it can complete the transaction, and you should do so sooner in the transaction. In particular, look at the buyer’s background, history and reputation, check any available financial records, and look for any legal judgments or pending litigation that could impact the buyer’s ability to close the transaction.
The bottom line for due diligence is that both sides to a merger or acquisition will want to verify certain information. It’s natural to want to do that for any major purchases. By keeping things confidential, limiting the scope of due diligence, and staying as organized as possible, you can reduce the due diligence headache and more quickly close the deal.
Structuring the Deal Generally
Now that we’ve walked through an overview of the industry, the professionals you will encounter in the M&A process, handling the purchase price and due diligence, as well as the key operating metrics for engineering firms, it is time to dive into the “lawyer stuff.” That is, how should the transaction be structured?
When an engineering firm owner decides to sell their business, they may choose to sell assets, stock or merge based simply on what the buyer wants to do (or what the broker recommends, which is often an asset purchase because they aren’t licensed to sell stock or perhaps they understand asset sales more than stock sales or mergers). Many times, firms don’t understand the financial and legal ramifications of the transaction structure. So, it’s important to have a reliable business attorney specializing in transactions involving engineering firms who can help guide you through the M&A process and, specifically, structuring the deal.
In terms of structuring the deal, there are three options to pick from: an asset purchase, stock sale or merger. Which one you pick depends on several factors like legal issues involving liabilities and risk, tax issues, the type of entities involved in the transaction, the number and type of contracts to be transferred to the purchase and more.
Let’s start with the asset purchase, as it is the transaction structure that is most simple to understand. When you buy or sell assets, all you are doing is buying or selling specific assets like contracts, goodwill, customer lists, books and records, and other assets directly from an engineering firm. It’s similar in many respects to buying groceries. Sometimes, buyers will also acquire certain specified liabilities that come with the specified assets. At the end of the transaction, both buyer and seller still exist as separate entities, but the identified assets and liabilities have switched hands.
So, what are the pros and cons of using an asset purchase structure instead of, say, a stock sale? For the buyer, there can be many benefits. The biggest benefit is that you can pick and choose which assets and liabilities to purchase and which ones you want to leave behind, which saves money that might otherwise be spent on unwanted assets. Another major benefit is avoiding assuming unknown liabilities or all the seller’s liabilities, as would be the case in a stock sale. Moreover, there can be tax benefits for the buyer if it structures the transaction as an asset sale because the buyer can increase the book value of the assets to fair market value when placing the assets on its books, whereas in a stock sale the book value of the assets is generally fixed (the book value on the seller’s books is what is used to value the assets on the books of the new buyer-owner). Higher book value means greater depreciation, which reduces income taxes.
Sellers of engineering firms may not be as keen on asset sales for two reasons. First, they must retain all known and unknown liabilities. And second, there are typically better tax consequences for the seller of an engineering company if it structures the transaction as a stock purchase (this isn’t always the case and it has to do with the current entity and taxation structure of the seller). So, these two reasons may result in the seller pushing for a stock sale instead of an asset purchase structure.
The next deal structure option is a stock sale, which means buying stock, limited liability company membership interests or any other equity interests from the owner of the engineering company. In this deal structure, the buyer acquires stock directly from the stockholders, which means the buyer also takes all rights, assets and liabilities.
From the buyer perspective, a stock sale may not always be the best option. For one thing, the buyer cannot as easily pick which assets and liabilities to purchase. In a stock deal, all the assets and liabilities transfer with the stock. There are some ways to address this situation by carving out certain items from the sales, although it can be complex. So buyers often must create small subsidiaries or negotiate specific contractual provisions to shield themselves from liability.
Sellers of engineering companies, in contrast with buyers, generally favor stock sales. Why? Because stock sales pass the responsibility for liabilities to the buyer, meaning the seller can usually ride off into the sunset. Moreover, sellers often have better tax consequences from stock sales.
There may be any number of reasons for structuring a deal as an asset sale or stock sale. Either option has its strengths and weaknesses, and oftentimes whichever transaction party has the most advantage can push for their preferred deal structure
A merger is the last option for the parties to consider. Defining a merger is relatively simple. It’s a stock acquisition where two (or more) companies merge into a singular, surviving entity. That surviving entity takes on all rights, assets and liabilities. There are two big buckets that all mergers fall into: (1) direct merger or (2) indirect merger. Within those two buckets, there are several variations of the merger process with names like forward merger, reverse triangular merger and more. But the bottom line for mergers is that there are different ways of structuring the merger to have better legal, tax and business consequences depending on if you are the buyer or seller of the engineering firm. Mergers are not very common with main street-type deals (transactions under $2 million) because they’re more complex than asset and stock sales and usually driven by significant tax considerations that don’t usually exist with smaller companies. Your M&A lawyer will provide guidance on whether this deal structure is right for your firm.
Specific Transaction Tools – The Earn Out, Seller Financing and One-Step vs. Two-Step Closings
Next, let’s walk through a few topics that could be factors in the deal negotiations. The first is called an earn out (or earn-out), which just means money paid out over time based on performance. If the buyer and seller each think the engineering firm is worth considerably different amounts, an earn out might be a good solution that splits the risk between the parties. If after the closing the target engineering firm performs to certain standards agreed to by the buyer and seller (such as growing the customer base or achieving EBITDA or revenue milestones), the total purchase price for the engineering firm could increase. In sum, an earn out is a good way for both parties to split the risk. If you as the buyer of an engineering company include an earn out in your purchase agreement, it might be very valuable to ask the seller to stay on at the engineering firm once the deal closes to ensure certain targets are met. Yes, you’ll pay more given the structure of the earn out, although ultimately that benefits you as the buyer anyway.
In the M&A process, a buyer may ask you, as the seller of an engineering firm, to finance some of their business acquisition by holding a promissory note for a portion of the purchase price (this is a legal document evidencing the buyer’s unconditional promise to pay). Actually, the buyer might ask you to hold a note for the entire purchase price, although I can guess what you answer to that request would likely be! The loan can be payable on demand or, as is most often the case, on a specified date.
If the buyer pushes for seller financing via a promissory note, the seller should determine how it can minimize its risk in financing the transaction. The seller wants to make sure it is paid in full and on time. One key way to do this is to secure the note with buyer assets. This is called security for the loan. It means if the buyer defaults on the loan, you can foreclose on the security and recover some assets to offset your loss. Without security, if the buyer files for bankruptcy, you may not recover much. This isn’t always easy to do, though. It depends often on whether the buyer already has financing on its business. If it has a credit facility, the lender may already have a lien on all the buyer’s assets. While you can try to carve out certain assets (e.g., the assets of the business you are selling is a good place to start) to serve as security for the seller financing, some lenders won’t allow this.
Another issue to consider is whether the deal will be done as a one-step sign and close or as a two-step deal (sign today and close on another date). Why would you want to separate out the signing and the closing? One reason for splitting the two dates out is that the transaction requires regulatory approval. Or, the buyer and/or seller may need to obtain other consents. This could include customer contracts, signings or even meeting with employees. If the buyer is a public company, separating the signing and closing is key because the transaction typically requires board and stockholder approval. Private deals require those approvals, as well, although they take much longer to obtain with a public company, especially shareholder approval if it’s necessary, which it usually is in the case of a sale.
Documenting the Deal – The Asset or Stock Purchase Agreement
Once you have identified the deal structure for selling or buying an engineering company, it’s time to begin documenting the deal. Like the deal structure, there are three types of agreements that you might use depending on the structure of the transaction. For asset purchases, you use an asset purchase agreement, which is also known as a P&S agreement (purchase and sale agreement). For stock sales, you’ll rely on a stock purchase agreement or, again, a P&S agreement. In those instances when the engineering firm is being merged into another company, you will use what is known as a merger agreement. These names are fairly intuitive, right?
Something else that is fairly intuitive is a concept called the “power of the pen.” What this phrase means is that, typically, you want the opportunity to draft the agreement – whatever kind it might be – before anyone else touches it. It’s an advantage to have your counsel prepare the document. Why? When most attorneys review an agreement that they did not draft, they will limit their comments to some degree. So, there is a benefit to being the one to draft the agreement because you can insert all the key provisions you believe are vital to the transaction. Little nuances can make big differences in these transactions, so having the power of the pen can be critical. However, in a direct, negotiated sale, the buyer’s counsel typically prepares the first draft of the purchase agreement. If you are selling an engineering firm, it’s unlikely that you will have the power of the pen at first, which just means you need a skilled business attorney with experience in the M&A space and engineering industry to assist you.
Regardless of the type of agreement, it will contain standard sections. These sections are called the articles and you can think of them as general subject areas in the agreement. A typical purchase contract will contain the following articles:
- Purchase and Closing Details – Purchase price, what is being purchased, when the closing takes place, documents exchanged at closing, and more
- Representations and Warranties of Seller
- Representations and Warranties of Buyer
- Covenants – Covenants might be just between signing and closing or apply post-closing
- Conditions to Closing – Applies only if there are two steps between signing and closing
- Indemnification – this is the promise of each party to make the other party whole (pay damages or defend a lawsuit) if there is a breach of the representations and warranties
- Termination – only applies if it’s a two-step sign and close transaction
Let’s look at some of the more important provisions. Obviously, the Purchase and Closing Details section is vital, as it describes the type of transaction (asset purchase, stock purchase or merger and, if it is the latter, what type of merger) among other vital provisions. Your M&A lawyer will help ensure that these provisions accurately reflect the business deal.
Another very important section is Representations and Warranties. This section is where the seller of an engineering firm represents the condition of the business. In a one-step sign and close the representations and warranties are as of the date of signing. In a two-step transaction, the seller provides the representations and warranties as of the day of signing and the day of closing (the buyer will usually require a “bring down” certificate that says, essentially, all the representations and warranties are true in all material respects as of the closing date. A seller may make 20 or more representations – things such as whether this is litigation, that the assets being sold (or stock) are owned free and clear, that the intellectual property being sold does not infringe any third party’s rights and that the financial statements are true and correct. The buyer of an engineering company will likely also make several representations and warranties, although far fewer than the seller.
And that statement being true can be vital for the transaction. For example, if the seller of an engineering firm does not own the assets being sold (which is a representation the buyer will require), then the buyer has a huge problem. Likewise, if the buyer represents that it has gotten all approvals required for it to close the deal, but made an error of some kind that tanks the deal, then that could stop the transaction dead in its tracks.
The representations and warranties are also important from a liability and risk allocation standpoint. If the buyer is not willing to state, for example, that it has all approvals necessary for the deal, that should raise a red flag for the seller. Similarly, if the seller cannot represent that the assets sold are in good working condition (normal wear and tear excepted), then the buyer will likely want to dive back into the due diligence and verify the condition of the assets. In these ways, the representations and warranties are used to uncover due diligence issues or barriers to closing the transaction.
Other times, the representations and warranties merely shift risk between the parties. For example, if the seller makes a representation to the buyer that there are no undisclosed liabilities affecting the business and it turns out there was something, even if the seller didn’t know about it (for example, an ex-employee may be preparing a lawsuit at the time of signing the purchase agreement, but the employee has not filed the lawsuit or even told the company that it’s forthcoming – arguably this is an existing liability), the seller will be responsible for indemnifying the buyer post-closing. Representations and warranties are heavily negotiated in any transaction and attorneys will fight to include qualifying words, such as “to the Seller’s knowledge,” which, if used in the case of the example above with the unknown employee lawsuit brewing, would not trigger a requirement for the seller to indemnify the buyer unless the seller knew about the lawsuit (and to take it a step further, purchase agreements will often define what it means to “know” something – is it actual knowledge or the knowledge the seller should have if they were paying attention).
Another important provision is the non-compete or non-solicitation section. With this section, you as the buyer of an engineering firm in Texas will try to prevent the seller from selling you their firm and then immediately turning around to open a new firm directly competing with the business or assets you just acquired. That would devalue the main merger or acquisition and could lead to loss of customers or whatever economic value underlies the transaction. In the Texas market, we typically see 3-6 years where the seller of an engineering company or the owners of the engineering firm cannot compete with the buyer.
Sellers may not have a ton of advantage for the non-compete or non-solicitation section of a purchase agreement, but make sure you consult with your business attorney before agreeing to these terms. You don’t want to box yourself out of a future endeavor or better job opportunity – if available.
The Lowdown on Buying or Selling an Engineering Firm (in Austin, Texas and Beyond) – Part 3
Other M&A Contracts and Documents
Prior to signing the purchase agreement, a buyer and seller in an M&A deal often sign a letter of intent (LOI). The letter of intent lays out the key terms of the deal. It is usually non-binding, except for confidentiality and exclusivity (the seller agrees for some period of time – often 90 days). Still, it saves time to document the terms in an LOI and it usually fleshes out if a party if not really serious because, even the document is non-binding, it costs some money to negotiate if attorneys are involved and most people don’t want to sign a document if they don’t really intend to follow through and close a deal.
There are other important but ancillary documents that come up in the M&A process depending on the specifics of each deal. These ancillary documents include:
- Bill of Sale
- Bring-Down Certificate
- Resolutions of Board/Managers and Shareholders/Members of Seller
- Resolutions of Board/Managers and Shareholders/Members of Buyer
These ancillary documents are important to the merger or acquisition, although they aren’t usually the subject of heavy negotiation.
Assignments and Transfers of Contracts and Other Assets
One issue on which buyers and sellers of businesses and their M&A attorneys spend a lot of time involves the assignment of contracts. Remember all the “boilerplate” language included at the end of most contracts you’ve signed? Well, some of those contracts may have “anti-assignment” or “change of control” provisions, which can haunt the transaction and drive up costs as you work with other parties to get their approval for the merger or acquisition. One thing your corporate attorney (or someone else on your team) will do is review all your firm’s contracts and determine how to structure the deal to minimize your exposure to any existing agreements with anti-assignment or change of control provisions.
The general position in U.S. contract law is that contracts are freely assignable unless they say otherwise. U.S. courts like free trade. As with just about every area of the law, there are some exceptions, such as contracts involving professional or artistic skills (if our contract instead says I’ll pay you $100 to sing at my daughter’s wedding, your services are considered unique and personal and you can’t just assign away your obligation in that case). Nevertheless, the general rule is that contracts are freely assignable. So, if a contract (other than a personal services contract) does not have an anti-assignment or change of control provision, then you should be free to assign it to the buyer of your engineering firm without getting approval from the other party to the contract.
However, most commercial contracts say otherwise, i.e., they have restrictions on assignment. Often, though, the restriction is a prohibition on assignment that is only triggered in the case of an asset sale. If you sell the stock of your engineering firm, the contracts aren’t assigned at all. They stay in place with the company whose stock is being sold. All that is transferred is the actual stock – from the shareholders (or members in an LLC or partners in a limited partnership or another type of partnership) to the new buyer. The contract remains in place, untouched. Your stock changed hands, but no one assigned the contract.
The ideal way to handle anti-assignment provisions is to approach the seller’s counterparties (the other party to each contract) and ask them each to sign a Consent to Assignment. This takes time, though, and the counterparties tend to be slow to respond or may have zero interest in helping. If cost, time or counterparty leverage plays against the parties approaching contract counterparties and obtaining consents to assignment, the buyer and seller will need to decide how to handle this issue. Your business attorney will be your ally during this process – and, indeed, the entire M&A process – so rely on their counsel.
Commercial leases and bank loans are particularly tough to assign. In a commercial lease, the landlord has a lot of leverage over the buyer. The buyer can’t easily go somewhere else. This represents an opportunity for the landlord to leverage the situation for its gain. With bank loans, the bank will be understandably concerned about the credit quality of the buyer. The bank did not underwrite the loan for the buyer – it was underwritten specifically for the seller. Moreover, assigning a commercial loan may trigger a “default” that results in repayment for all loaned money being due now.
I can only think of one deal I was involved in where the parties agreed to close the deal, knowing it violated a loan agreement. In all the other circumstances I can think of, the debt is paid off or the parties approached the bank before closing and the buyer was underwritten and the bank provided its consent. In that one case, it didn’t end well. The bank ultimately said, “No,” to taking on the buyer and the buyer was forced to scramble and come up with money to pay off the bank loan, which went into immediate default when the deal was closed. That was a business risk the buyer took. M&A deals are all about risk, but you want to be sure you fully understand where the risks lie and great advisors will help you do that.
Working Capital Targets and Work in Progress (WIP)
In stock purchases, where the purchaser acquires the stock (or other equity interests) of the seller (stepping directly into the shoes of the current owners of the seller stock), the purchaser usually takes over the accounts receivable and accounts payable of the selling engineering firm. This isn’t always the case in asset purchases. Sometimes, buyers don’t take over either the accounts receivable or accounts payable. Other times, buyers of engineering firms take over one and not the other. Buyers, of course, prefer to take over the accounts receivable, not the accounts payable.
When buyers agree to take over both accounts receivable and accounts payable, the parties will typically negotiate a target figure for working capital. Determining working capital — a way of measuring an engineering company’s efficiency — is simple. To get working capital and see how financially healthy the firm is in the short term, you just subtract current liabilities from current assets.
Because it isn’t usually feasible for a seller of an engineering consulting company to know exactly what the working capital is on the day of the closing, the seller usually delivers a preliminary balance sheet to the purchaser at or right before the closing. Over the next few weeks, the buyer will perform its own calculation of the actual working capital of the business on the day of closing. If actual working capital is less than the target figure, the seller pays the buyer a true-up payment. If actual working capital is more than the target, the purchaser pays the seller a true-up payment.
So, if you structure the deal as an asset purchase agreement, you will probably not have to deal as extensively with working capital. But if the deal for the engineering firm is structured as a stock purchase, working capital and working capital targets will more than likely pop up. It is important to have both experienced M&A attorneys and accountants who can help you with these provisions.
Your deal team will also help you with a semi-unique feature of engineering firm transactions. In engineering firms, an issue that doesn’t show up in most deals in other industries involves work in process (or work in progress). We’ll refer to both as WIP.
Because most engineering firms work on long-term projects with flat fees, they often have current projects in progress when a buyer swooped in to purchase the firm or the owner decides to sell. WIP becomes a consideration for the buyer who will want to understand where the project is relative to the fees that will be billed for the project. Is the project coming along on time and is it over or under budget? If the project is performed on a flat fee basis and the remaining work is much greater than the amount left to bill, either because the seller front-loaded the fees or mispriced the project and is having to put in more time than it will be paid for, the buyer will look to the seller for compensation. After all, no one wants to buy a business where there is a lot of work promised to customers but for which the customers no longer must pay. A similar issue pops up with gift cards in retail businesses – it’s the same basic principle. Buyers want to understand what they’ll owe to customers but for which they won’t be able to charge those customers.
Why Purchase an Existing Engineering Firm Rather Than Starting One?
To understand M&A, it’s important to understand the motivations of buyers and sellers. Sellers are generally looking to cash out and go do something else or realize joining a larger firm through a sale and acquisition may provide better opportunities to compete in the marketplace. Buyers, on the other hand, are generally interested in quickly gaining market share in existing markets or buying their way into new markets or new service lines. There are other motivations to do M&A deals, although these are common ones.
Buying an existing firm has its benefits. Buying may be quicker and give you an established clientele from the start. The name recognition may be another benefit, but only if the firm has a stellar reputation among engineering clients. But before acquiring an existing engineering company, buyers should conduct thorough due diligence to see whether it’s a good idea to buy and to understand why the current owner is selling. Owners may sell because the firm is not doing well financially, or the owners are exhausted and just want out. As part of the investigation, buyers should evaluate the reputation of the selling company. The Better Business Bureau serves as a trustworthy resource for potential buyers to see reviews of engineering firms and customer disputes. You may be able to solve tangible problems like poor project workflows, for example, but it can be hard to salvage a burned reputation. Nevertheless, an inefficiency may be the driver behind your interest in acquiring the firm so you can correct the inefficiency and improve financials, so even a damaged reputation is not a deal killer per se.
Buying a financially successful engineering firm comes at a premium. For a successful firm in the engineering industry, a buyer will pay a multiple of sales, not just the asset value. If a business isn’t financially successful, that doesn’t mean it isn’t worth buying. New management may be the solution to turning the place around, although tread cautiously. You want to be 100% sure it’s poor management and not a bad reputation or some other insurmountable issue. And, keep in mind that convincing employees or customers to stick with the firm once it changes ownership can be tough. You must communicate to them that management has changed and, even then, some won’t think it’s worth the risk versus going somewhere more “reputable.”
Licensing and Permitting
Whether the buyer of an engineering consulting firm in Texas is acquiring stock in the engineering firm or assets or merging companies, the purchaser wants to make sure that they are getting a legally compliant business. Part of legal compliance is ensuring proper licensing of the company and engineers working in it.
The website for the Texas Board of Professional Engineers lays out the requirements for working as an engineer in Texas clearly: “Under the Texas Engineering Practice Act, only duly licensed persons may legally perform, or offer to perform engineering services for the public. Furthermore, public works must be designed and constructed under the direct supervision of a licensed professional engineer. The terms ‘engineer’ or ‘professional engineer’ can only be used by persons who are currently licensed. Anyone who violates these parameters is subject to legal penalties.” You can read more about the requirements to become a professionally licensed engineer in Texas here.
If the buyer plans on hiring certain engineers as part of the merger or acquisition, then it will look for assurances that those engineers have all licenses in place and can practice in Texas. The key requirements for being a licensed engineer are:
- Must have graduated from an approved curriculum in engineering or related science (B.S., M.S., or Ph.D.)
- Depending on degree accreditation, must have a minimum of 4 or 8 years of creditable engineering experience referenced by a P.E. (Professional Engineer), and
- Must have passed the Fundamentals of Engineering (FE) Examination
Again, this information is from TBPE’s website.
The second item of concern for buyers of engineering firms in Texas is the required permits. While the State of Texas does not require a general business license, regulatory agencies may have licensing and permitting requirements based on the type of business. For engineering firms, the State of Texas requires that “any entity offering engineering services to the public of Texas must register with the [TBPE].” The buyer will want to make sure that the new entity or merged firm meets the TBPE’s requirements for permits so that the firm can continue running as a profitable business.
To register an entity, an engineering firm must complete the form “Firm Application for Registration.” For information on engineering firm licensing requirements in other states, read this American Bar Association 50-state survey of engineering firm licensing requirements.
Ultimately, the buyer of an engineering consulting firm will want to make sure that the licenses and permits for the firm and its engineers are updated and in compliance with all applicable laws.
Other Considerations When Buying Engineering Firm
I talked earlier about the weight of debt on the financials of any business. Instead of borrowing money, you can also take on investors and give them equity in your engineering consulting firm in Texas. But whenever you raise capital from investors, you must comply with federal and state securities laws. So, it’s time to call an attorney. Specifically, experienced corporate attorneys who can help you navigate these issues and how to structure the deal.
What if you want to have those investors play a more direct role in your engineering consulting firm? Well, then bringing them on as partners might be a good option. Having partners to share the workload and to commiserate on down days (these exist in any new venture – trust me!) is invaluable.
Additional Resources for Growing an Engineering Firm in Austin, Texas
If you purchase an engineering firm in the Austin, Texas area with the intention of growing it (possibly to sell to a different purchaser), you can find a great list of resources here, although I list a few key ones below, as well.
Austin’s Small Business Program http://www.austintexas.gov/department/small-business-development-program
This site a great starting point for anyone starting a small business in Austin. Here, you’ll find classes, events, and more.
Locally Austin http://locallyaustin.org/
A tool for locally owned small businesses in the Austin community. It can serve as a great resource to research other businesses in your field and a place you should definitely list your business if you’re local to Austin.
Austin SCORE http://www.austinscore.org/
Receive mentoring and advice from local volunteers and fellow entrepreneurs.
BIG Austin http://bigaustin.org/
BiGAUSTIN is a Central Texas non-profit for entrepreneurial education, tailored business counseling and flexible loans.
Texas Economic Development Corporation Resources https://texaswideopenforbusiness.com/resources/reports-directories
At the TxEDC, you’ll find loads more resources from economic reports by industry to legal requirements and tax structures.
Capital Factory https://capitalfactory.com/
Capital Factory is a hub for entrepreneurs in Austin. It’s a co-working space, incubator, and great source for education and networking opportunities.
Tech Ranch https://techranchaustin.com/
Tech Ranch is another supportive entrepreneurial community local to Austin. You can find a coworking, office space or programs to help grow your endeavor.
How does a Mergers and Acquisitions Lawyer Help?
While lawyers won’t usually help with the engineering firm’s client relations or business development, a business lawyer can help you navigate the path from owner of an engineering company in Texas to whatever your exit option might be – think retirement or your next endeavor. You should think of an experienced corporate attorney as the quarterback of your legal team.
As a corporate attorney, I help engineering companies raise capital (securities law), purchase existing engineering firms or other businesses (mergers and acquisitions law), sell engineering firms and handle a wide variety of other transaction and contract-related issues, including negotiating and drafting master service agreements. I do this in Austin, Houston, Dallas and other areas of Texas and the United States.
If you want a trusted advisor to jumpstart your new venture, call me at 512.888.9860. I am happy to discuss your plans for the engineering firm. As your business attorney, I can help you accomplish your goal of selling or buying an engineering consulting company.