Ownership Transition: When Things Don’t Work Out as Planned

0By Robert P. Smith, AIA

0It seems to me that many, if not most, ownership transition (OT) plans are initiated during “good times”. This is understandable – the firm is growing, backlog is strong, revenues are high, profits are solid, new people are joining the firm, seasoned staff are experiencing upward mobility, compensation is rising, aging shareholders are beginning to ponder ‘life after architecture’. In short, both potential sellers and potential buyers possess the right frame of mind to discuss the transfer of shares from one generation to the next. This seems natural enough.

0However, during periods of economic prosperity, there also is a tendency to believe that the operating environment – both internally and externally – will remain constant over time. Regrettably, as we’ve all been reminded during the past few years, “hard times” revisit our profession with uncomfortable regularity.

0Since a full-blown ownership transition plan generally requires several years to implement (often 5-10 years when multiple players are involved) the complete transition of ownership from one generation to the next is likely to overlap at least one recession. When this overlap occurs, unpleasant surprises can occur. In severe cases, the OT plan itself can collapse.

0For some very good reasons, firms rarely can just abandon an OT plan simply because it becomes ‘inconvenient’ during a downturn – too many people have important personal plans already in motion to make wholesale abandonment a practical consideration. Of course, if all the parties are willing to cooperate, certain adjustments can be negotiated ‘on the fly’. However, because the parties involved in an OT plan often have conflicting interests, it’s always better to anticipate major uncertainties at the time OT plans are being formulated. While the plan still is in the formative stages, the firm can incorporate reasonable mechanisms that will produce balanced and fair solutions when adverse operating conditions arise unexpectedly.

0Let’s look briefly at five conditions – each with significant OT implications – that frequently occur as the economy sours:

0• Severe decline in the firm’s backlog and cash flow – this is the most obvious. As the economy worsens, most design firms experience a weakening of revenue, a decline in backlog and diminished cash flow. Belts tighten across the board – especially among those either preparing for imminent retirement or engaged in the acquisition of some portion of the firm’s shares. The scarcity of cash – at a time when an abundance of cash is needed – can create considerable tension between the selling and buying parties.

0• Loss of employees who might be buyers – downturns often cause firms to shrink in size. This shrinkage can cause good employees to leave the firm, including some who – during better times – the firm was counting on to purchase shares of retiring shareholders. This loss of key employees can diminish severely the marketability of a retiring principal’s shares.

0• Unanticipated loss of shareholders – a downturn sometimes can cause existing shareholders to leave the firm prematurely. These departures may be the sole decision of the shareholder (i.e. early retirement) or the sole decision of the firm (i.e. too many expensive shareholders for the firm’s current size and revenues.) Either way, the cash required to suddenly fund these early buy-outs can become a severe – perhaps insurmountable – problem, especially in an environment characterized by declining compensation and cash flow.

0• Shrinkage of sellers’ retirement portfolios – downturns also can have a devastating impact on the value of retiring shareholders’ investment portfolios, motivating those senior professional to delay retirement as long as possible. This delay gives their investment portfolios more time to recover and allows the withdrawing principals to maintain their salaries for a few more years, further lessening the erosion of their investment portfolio. These are legitimate considerations from the perspective of the selling shareholder, but may bring about resentment and frustration among the next generation, which typically is eager to assume full operational control as early as possible.

0• Unanticipated behavior – downturns are inherently stressful and that stress sometimes causes otherwise dedicated, and rational, shareholders to behave erratically. Previously unseen behaviors like loss of motivation, outbursts of anger, ethical lapses, excessive concentration on compensation matters, etc. can surface – especially among shareholders who are experiencing a recession for the first time as an owner. This erratic behavior can produce stress cracks in otherwise solid ownership dynamics, to the point where individuals may begin to question their commitment to remaining a shareholder and the firm may begin to question earlier decisions to bring certain individuals into positions of ownership.

0While there are other possible troubles, taken as a whole these sorts of problems can exacerbate the already considerable uncertainties in a design firm’s operating environment. That uncertainty produces high levels of anxiety – even antagonism – among potential sellers and potential buyers. OT transactions that otherwise might be relatively easy to implement during “good times” suddenly become much more complicated, if not impossible, to complete.

Flexibility is the key.

0Ownership transition plans should strive to achieve a reasonable balance between “predictability” and “flexibility”. Both buyers and sellers need (and want) some reasonable capacity to predict exactly how the OT will unfold – within reasonable limits. However, because we operate in an uncertain environment, firms developing OT plans must do so in a manner that reflects that inescapable uncertainty.

0For example, in hard times, it is not uncommon for an existing shareholder to unexpectedly and unilaterally decide that he (or she) wants to retire early – perhaps because work isn’t much fun any more, or perhaps in order to lock in a higher share price than might otherwise be available if he (she) delayed retirement for another few years.

0When this happens, if there are no other qualified employees available with the means to purchase the retiring shareholder’s shares, in most cases the firm will be obligated to acquire those shares – probably under conditions when cash already is scarce. To accommodate a ‘surprise’ like this, firms should build flexibility into their OT plans by giving the Board the discretion to lengthen the payout period (say, from three years to five) when a shareholder unilaterally decides to start selling shares prior to normal retirement age – i.e. prior to age 65.

0Even in good economic times, ownership transition can be a very complex process for most firms – especially small to medium sized firms that don’t experience the routine transfer of shares among employees. When a severe economic downturn overlaps an already complex process, bad things can happen, especially when those contingencies were not adequately considered when the plan was designed originally.

0Firms wishing to undertake an orderly OT process already must grapple with the large range of unfamiliar issues. For the reasons outlined above, such firms also need to take whatever additional time is necessary to think about possible ‘worst case scenarios’ and decide – in advance – how the group of shareholders will respond if such scenarios do, in fact, become a reality.

About the author: In 1981 Robert P. Smith AIA established a consulting firm that operates today as ManageYourDesignFirm.com. Robert holds a B. Architecture degree from GA Tech and an MBA from Harvard. During his career, Robert has allocated his time among three main activities: a) design firm management; b) real estate development; and c) management consulting. This broad exposure to the many dimensions of our industry provides Robert with an unusually robust perspective on what is needed for a design firm to achieve success – and sustain that success – over time.

0Robert can be reached at robert.smith@ManageYourDesignFirm.com and he welcomes your questions and/or comments about this article.

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