Pot of Gold?

“I’m planning on making some major changes in my life, ” Barry Waldheim told me in my office. Barry has been a friend and client for nearly 15 years. “I don’t want to work as hard as I have been and I want to sell my shares in my firm.”

“This is momentous,” I said. “Have you discussed your thoughts with your partners?”

“I mentioned it to a couple of the guys, but I must admit I didn’t get much response. Some time ago we received advice about setting a formula for the sale of shares as part of our shareholder agreement. The idea was that the surviving shareholders would purchase the shares of a departing partner. We never did anything about it, though. We found it difficult to establish a rule for purchasing shares when we suspected that several of us would want to quit at the same time.”

“And do you think some of your partners will want to retire soon?”

“That would be my guess. We have six shareholders. Four are over 55. I’m the second oldest at 61. The two youngest are in their mid-40s. The reason I’m here today is to discuss how to value our company. I looked up some public engineering corporations. Their stocks sold for 12 to 16 times earnings. We’ve been earning about $1 million per year after tax, so my guess is that our firm is worth about $12 or $14 million. I own 20%, so by my lights I suppose I’m a rich man,” Barry grinned.

“Who’s going to buy your shares from you?’

“It doesn’t really matter does it?”

“Actually it does. You can only sell your shares if someone else wants to buy them. If your shareholder agreement does not force a purchase to your partners you may not find any buyers at all. My guess is that your natural buyers are (1) your existing partners, (2) some new partners that your firm might elevate to shareholder status, or (3) another firm — either public or private — that would like to take over your business.

“In any of those cases, it’s not likely that you’ll receive 12 times earnings for your shares. According to economic theory, your company’s shares should be worth the discounted value of future earnings. That’s called going concern value, and it is based on the separation of the business from its management. When an analyst looks at a public engineering company with four or five thousand employees, he sees a continuing enterprise that is not tied to the efforts of a small group of people. He expects the entity to have a life of its own. In a private company the ability of the business to continue is often closely bound to the expertise and contacts of a few individuals. That’s one reason why firms often bring in young partners to buy the shares of retiring members. They want a younger partner to take over the practice of the older one, inherit his contacts, develop new ones and continue the area of expertise within the firm.

“So what are my shares worth?” Barry asked.

“I have no idea,” I said. “A great deal depends on what you are selling. If the business that you control will expire once you leave the firm, your shares are probably not worth very much. The less the business depends on your efforts, the more valuable it is. And of course, if the business can exist separately from you, you might even find an outside purchaser if your own partners aren’t interested. Often private businesses are sold on the basis of an “earn out” arrangement, and that might facilitate a sale in your case.”

“I’ve heard that term before, but usually in a mining context.”

“When selling a business, an earn out is a compromise mechanism that can bring vendors and purchasers closer together. The vendor usually has an idea of how much business will continue in the future, and he or she would want to base the price on that estimate. On the other hand, the purchaser may not feel safe depending on the vendor’s numbers. To lower the risk, both parties may agree on a price on revenues or profits from existing customers. Then each year, a payment determined by the actual results of the purchaser is made to the vendor.”

“I don’t follow you,” Barry said.

“Assume all six of your partners decided to sell the business to some other company. You estimate that the continuing profits from your business will be $1 million per year for the next five years. The purchaser then agrees to purchase the shares of the company for, say, $4 million, based on your projections. However, the actual payment will be 80% of net profits for each of the next five years. If the profits in year one are $1.5 million, the purchaser pays $1.2 million that year, and so on. If the profits dwindle to $300,000, the purchaser pays only $240,000 in that year. The price paid is actually based on the profits earned over a predetermined time period. A mechanism like this takes away much of the risk for the purchaser and may make a deal more likely to occur.”

“It’s a good idea,” Barry said, “but it doesn’t help me with my partners, does it?”

“It may. There’s no reason why you couldn’t sell your own practice on an earnout basis to your existing partners. But given their age and inclinations, it might make more sense for the company as a whole to work on a succession strategy.”

“What about the building owned by the practice? It’s worth about $2 million, and I wouldn’t want to tie its value to the future performance of the firm.”

“Of course not. If you sell the building or a share of it, that sale should be made at fair market value. But you should be aware that a prospective purchaser of the practice may not want to buy the building, either because of the cost involved or because buying real estate is not within the buyer’s mandate. It’s best to regard your investment in the building as a separate asset from the practice — you can either sell it to your remaining partners or the partnership can create a separate entity to hold the real estate. In general a purchaser of an engineering practice buys practice assets only as a way of obtaining potential earnings. Your purchaser will likely regard the building, your computer systems and your other assets simply as a means to an end … and that end is leveraging profitability by obtaining access to clients and the systems and personnel to service them.”CCE

Hank T. Bulmash, C.A. is a partner with Bullmash Cullemore, Chartered Accountants of Toronto.