How to navigate through leadership and ownership transition
Consider all the elements of the transition process, from developing new leaders to planning ahead
Of the many strategic and operational elements that capture the attention of firm owners, high on the list is evolution of ownership. Treating it like an ownership issue alone, however, dramatically understates and misrepresents the challenge and the opportunity. The real issue is expansion of leadership and ownership, followed by the transition itself. At least 90 percent of the time, the first major change is the growth of leadership and ownership groups. This can lead to some owners divesting ownership, which may or may not coincide with their departures from the firm.
To simplify the overall picture, it can help to consider the difficulty of various transition components. We will go through them all, ranked from least to most difficult.
Ownership transition, though not necessarily simple, is mechanical in nature. Determine how to value ownership—recognizing that sellers can adjust the price circumstantially—and recognize this critical truism: There is no such thing as truly successful ownership transition in a marginally profitable firm. “Truly successful,” in this situation, means providing fair value to sellers, being affordable to buyers, and serving the firm's best interests by bringing the right people into ownership at the right time.
In a transition, no rules apply universally except for the above. Having said that, some empirical data from a large database might help:
To keep financial data in simple terms, the average valuation for internal transition purposes equates to 25 percent to 30 percent of annual net revenue (defined as "gross revenue less consultants and non-labor project expenses").
The average valuation for external transition—sale to an outside buyer—is about twice the internal price, or 50 percent to 60 percent of annual net revenue. More highly valued firms can sell for as much as 100 percent of annual net revenue or more, but that is rare. This is the “goodwill value,” which comes in above the liquid value (primarily cash and receivables).
Ownership transition, though not necessarily simple, is mechanical in nature.
Minimal operating profitability (before retirement plan contributions and bonuses) to sustain competitive compensation and fund ongoing, incremental ownership transition is 10 percent of net revenue, which explains why so many firms deferred ownership transition during the economic downturn of 2008-2012, when average profitability dropped to 5 percent.
Sellers who expect to get rich or fund their retirement exclusively from the divestiture of their ownership will be disappointed. The compensation math demonstrates that an owner for 30 years in an architecture firm is likely to receive over 95 percent of remuneration in the form of salary and distributions and less than 5 percent from the sale of ownership.
Overpricing ownership will lead to departures of the next leaders and owners; if they are good enough to be successors, they are good enough to be competitors.
Three more transition components
Management transition, referring to orchestrating people and resources, is relatively simple because most people follow instructions from even unenthused managers.
Identifying, developing, and retaining future leaders is the biggest challenge.
Governance transition, referring to participation in high-level decision-making about strategy and policy, is more difficult for a few reasons. One is the magnitude of the issues which governance addresses. Another is that, with expansion of the governance group, new dynamics and relationships develop; a governance group’s effectiveness depends in part on the ability to air different views and come to good decisions in a timely way. Excessive deference by newcomers to established members impedes achieving the highest level of effectiveness.
Marketing and business development transition is a more significant challenge, to a large degree because people with the capability and passion to do those things well are few and far between. To the chagrin of many, simply being a competent practitioner—even with a focus on a specific typology—isn't enough. Another difficulty is the time it takes to earn credibility in the marketplace; too often the expectation is too much too soon, so the effort ends before results can reasonably be expected.
Leadership transition usually presents the biggest challenge, and the reasons warrant clarity. First, leadership has a fuzzy definition, with many people equating leadership with management. The real test of leadership is followship: If there’s no one following you, you’re not leading.
A second challenge is that many leaders are entrepreneurial; as a result, they often seek to create new opportunities rather than advance in existing organizations.
Sellers who expect to get rich or fund their retirement exclusively from the divestiture of their ownership will be disappointed.
A third challenge is that leaders are often impatient, which leads them to depart before the older generation thinks they are ready to step into leadership and/or ownership roles. This emphasizes generational patterns, with first-generation ownership characterized by entrepreneurialism and external focus (evidenced by the ability to bring work) and the second generation characterized by focusing on doing the work, developing the systems and processes for delivering work, and exhibiting patience (becoming owners at an average age of 41, whereas the average age of founders when they start their firms is 31).
In this overly simplified model, the third generation is more like the first than the second, and the patience of the second generation can impede leadership evolution. A firm needs the strengths of both first- and second-generation profiles. Absent one or the other, the firm’s chances to succeed diminish considerably.
Considered together, these various transition components tell us several things:
Identifying, developing, and retaining future leaders is the biggest challenge. In other words, the “who” is more often a bigger challenge than the “how.” It is wise to institute a transition plan early. Profitability is a necessity, and attaining the average of the profession in most years is barely enough. Finally, greed hurts transition.
Aspiring leaders can register for Leadership Institute 2016, a one-day leadership training event to be held on November 18. For additional resources on ownership transitions, visit the AIA Trust's resource page.
This story originally ran in the AIA Practice Management Digest for September 2016.
Hugh Hochberg leads The Coxe Group and has personally consulted with over 1,150 professional service firms. His clients include one-third of the firms that have won the AIA Firm Award. He can be reached at email@example.com.