By John Pruitt

Every day we are all determining "value." Deciding whether to indulge in the $4 dollar coffee drink at Starbucks, or just have a cup of "office" coffee and saving the $4, is a decision involving value. On a larger scale, owners and potential owners of businesses need to have an understanding of how value is determined, and also how to extract the value of the company when it is time to retire. This article is the first in a series that addresses specific valuation issues for A/E firms. The final installment will address how to get the value out of a business when owners retire.

The last quarter of 2001 was a reality check for many A/E firms. Where above average profits were accepted as commonplace, now profit margins were being squeezed. Some firms who aggressively expanded into new markets and locations in the late 1990’s were seriously impacted. Cash was pouring out…reserves were being used up at a surprising rate. A few A/E firms had further complicated their cash situation by purchasing other firms using all, or nearly all, cash deals. Well, the cash cow is now officially out to pasture…the all cash deals that occurred in the 1990’s and year 2000 will be fewer and farther between…at least for a while. As positive fallout from any economic downturn, there will be bargain purchases available to those who have liquid resources.

The change in our economic marketplace from boom to recession has dramatically affected the price of many business enterprises. The downturn in the stock market is a testament that the value of a business can change almost overnight. In a free market place, a change of circumstance such as lower profits than expected, lower future profit estimates, or a general degree of pessimism amongst owners or potential owners can affect the price of a business. The A/E industry is not exempt from price volatility.

A positive example of market driven valuation of a publicly traded company is URS Corporation, an engineering services company with sales in excess of $2 billion. The price of URS stock on January 18, 2001 was $15.00 a share. Almost one year later to the day, the stock was trading at $29.98 a share. How can a company almost double in value in one year? The answer is subject to considerable speculation. However, the prices for publicly traded stocks typically are affected by a myriad of events including: estimates of future company earnings, whether financial institutions are buying or selling the stock, whether company officers are buying or selling their shares, historical price-earnings performance, dividends paid or forecasted to be paid, stock price trend analysis, and even the latest company press release.

It is somewhat refreshing to realize that, in general, the A/E industry did not take the brunt of the fourth quarter downturn. However, the recent volatility of the stock market demonstrates the challenges of valuing any business.

Valuing an engineering or architectural service firm, where annual sales are in the $2 to $25 million range can often be challenging because of the lack of free market information. There are virtually no publicly traded A/E firms in that size range. However, if valuators spend sufficient time to analyze company information, collect relevant industry information, and interpret the information correctly using their professional knowledge and judgment, then an appropriate valuation can be determined.

Engineering and architectural firms are different than CPA, law, and medical practices. They are put together differently, their process of accomplishing and delivering professional services is substantially different. Even disciplines within an A/E firm can affect the valuation. A structural engineering firm will typically have a different valuation than say a civil firm with equal sales and profits.

The most perplexing part of valuing an engineering or architectural firm is the "human capital" element and other intangibles. In contrast, a manufacturing firm will have most of its value in fixed assets [property & equipment] and have a much smaller "human capital" element. Unique characteristics of A/E firms include:

• State regulatory bodies license the company and the individual professionals in the business.
• A specific course of study and professional certification is required for the professionals.
• Generally, there is a high degree of trust between the client and the professional.
• Employees/professionals of the company tend to have a collegial relationship with the owners/professionals.
• The company typically relies on client relationships built up over time by key company personnel.
• The company usually has a relatively small amount of fixed assets such as buildings, machinery, etc.

When considering value, there are various terms and valuation approaches that need to be understood. The underpinning of all valuations is to have a clear understanding of what is meant by "value."

The fair market value is the most widely encountered standard of value. The U.S. Treasury Regulations define fair market value as follows:

Other inherent characteristics of fair market value include:

• Dealing is at arm’s length.
• Willing buyer and seller are able as well as willing to buy or sell.
• Value reflects economic and market conditions prevalent as of the effective date of the valuation.
• Value is in terms of cash [or cash equivalents].
• Parties are well informed or advised.

This is one of the most misunderstood parts of company valuations. The purpose of the valuation will often affect the standard of value. As an example, the value of a firm’s stock for a buy-sell agreement may be anything the parties choose to agree on. In contrast, if the valuation purpose is for an Employee Stock Ownership Plan (ESOP), the applicable standard of value is the fair market value governed by both federal tax law and ERISA (Employee Retirement Income Security Act of 1974).

Another example of a difference in valuation standards is the investment value. A strategic acquisition is often equated to investment value. The primary difference between fair market value and investment value is that the investment value focuses on and reflects the circumstances of a particular buyer or seller rather than a hypothetical one. Investment value is reflected particularly in mergers and acquisitions involving strategic buyers…that is, those that have apparent synergies with the acquired company. These synergistic benefits may motivate the particular buyer to pay more than the fair market value of the company on a stand-alone basis.

Examples where a buyer may be willing to pay investment value to acquire a business are when the buyer wants to:

• Enter into a new geographic area.
• Offer a new product/service line.
• Become a more appropriate sized entity to do larger and more interesting projects.
• Become a larger size to attain efficiencies.
• Eliminate a pesky competitor.

The motivation for numerous mergers and acquisitions is that the buyers believe that they can operate the combined businesses more effectively than the individual companies. However, what all too often happens is that the efficiencies are more difficult to implement than the buyers anticipated, and the post-acquisition costs are substantially more than planned.

In the year 1959, the IRS published Revenue Ruling 59-60 that established guidelines for valuing the stock of closely held corporations. The Ruling has stood for over 40 years as the standard of what the U.S. government says valuators need to know and follow for a proper company valuation. While an IRS Ruling is not statutory law, it is usually a poor strategy to contradict the ruling unless there is something unique about the particular valuation.

Revenue Ruling 59-60 provides important insight into determining a value for a business enterprise. Some key points made in the Ruling are:

• Valuations are, in essence, a prophecy as to the future and must be based on facts available at the date of the appraisal.
• One should not solely rely on a "formula" approach to determine the value of a business enterprise.
• Company valuations are not an exact science…that elements of common sense, informed judgment and reasonableness must enter into the valuation process.
• The fair market value of a specific company will vary as general economic conditions change from "normal" to "boom" or "depression."
• Appraisers will often have a wide difference of opinions as to the fair market value of a company.

Revenue Ruling 59-60 counsels that when valuing a closely held corporation, the valuator should consider the following:

• The nature of the business and the history of the enterprise from its inception. The history of a corporate enterprise will show its past stability or instability, its growth or lack of growth, the diversity or lack of diversity of its operations, and other facts needed to form an opinion on the degree of risk involved in the business.
• The economic outlook in general and the condition and outlook of the specific industry in particular. Consideration of the national economy, local business conditions, industry specific circumstances, and prospective competition must be evaluated. The lack of management depth or trained personnel will also affect the value of a business.
• The book value of the company and the financial condition of the business. An analysis of the balance sheet and related financial statements must be considered. Issues such as liquidity or the lack thereof, the "quality" of the fixed assets, the amount of working capital and long-term indebtedness, and the capital structure must also be considered. Any assets not essential to the operation of the business such as investments in office buildings deserve special attention. [Note: Such investments are called non-operating assets and will command a lower rate of return than do the operating assets of a going concern.]
• The earnings capacity of the company. An analysis of the income statement for the current period and at least five prior years is part of judging the earnings capacity. Many valuators want to look at a full economic cycle of ten to twelve years to obtain a feel for both the good and poor times for the company. Revenue Ruling 59-60 goes on to state that prior earnings records usually are the most reliable guide as to the future expectancy; however, current trends should not be ignored. Adjustments to the income statement are typically necessary for non-recurring or unusual expenses. Officers’/owners’ compensation should be reviewed to ascertain if it is reasonable. [Note: Some S-Corporations underpay salaries for owner-employees, but make up the underpay with owner distributions; this strategy is sometimes used to reduce FICA taxes. Some C-Corporations overpay owner-employees; this strategy is sometimes used to avoid double-taxation issues associated with dividends.]
• The dividend-paying capacity. For engineering/architectural firms, the dividend factor is useful in determining whether the business can produce cash for a payout to investors. However, dividends-paying capacity for A/E firms is a less reliable criterion for fair market value than other more applicable factors.
• Whether or not the enterprise has goodwill or other intangible value. In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value rests upon the excess of net earnings over and above a fair return on the net tangible assets such as accounts receivable, work in process, equipment, less liabilities.
• Sales of the stock and size of the block of stock to be valued. The measure of fair market value requires that the sale be made at arm’s length. The size of the block of stock to be sold itself is a relevant factor to consider; however, it does not necessarily dictate either a higher or lower stock price for a "small" block of stock over a "large" block of stock. [Note: This tends to be another controversial area in company valuations.]
• The market price of stocks of corporations engaged in the same or a similar line of business having their stock actively traded in a free and open market. When evaluating an engineering or architectural firm, the challenge is to find comparative companies, with comparable service lines, in the same business cycle as the company being evaluated, that are actively traded on a major stock exchange. Most valuators of A/E firms do not place a high relevance on "comparables" simply because there are few publicly traded companies that come close to matching up with the company being valued.

The valuation of closely held companies entails the consideration of all relevant factors. Depending upon the circumstances in each case, certain factors will carry more weight than others because of the specific nature of the company’s business. Most valuators rely more on an earnings or a modified asset-basis approach to value an A/E firm. However, adequate consideration must be given to the capital structure, value of the underlying assets, project backlog, depth of management, and historical company information.

While this installment concentrated upon the concept of "value" and what should be considered when valuing an A/E business, the next installment article will examine the actual valuation process. In the next issue of A & E Business, the concepts of how capitalization and discount rates are determined will be examined, followed by an analysis of the three general approaches used to determine the value of professional service companies.

John Pruitt is President of A/E Consulting Services, Inc. and is a CPA, with an MBA in Finance. John has been awarded a Certificate of Education for Business Valuation by the AICPA, and is a frequent speaker at seminars and professional conferences. John may be reached at 425/827-2995.