Contractual arrangements for hiring at principal level 2

[hydro10]

Our hydrologic engineering consulting firm has been in business for 12 years, with two principals and (currently) four staff-level and project-level scientists & engineers. We are beginning conversations with a principal-level engineer at another firm, and he may join our firm if we all "click". I realize we'll need to offer him a stake in the company. At the same time, we do not want to give away the value of a company that we worked 12 years to build. What are some typical ways of structuring a contract at the principal level?
Incidently, the engineering firm I worked for previously eventually made me a "principal", and all that meant was a raise and new business cards -- no ownership. I'd appreciate any thoughts, links, references.

 

[hokie66]

Your company is worth something. If a new principal is to own a part of the company, he should be willing to pay for it.

 

[Ron]

I agree with hokie66. Do a time-structured buy-in, with a cap on percent ownership. If he works out, then you can re-structure. If he doesn't work out, be sure you have enough capital to buy him out when he leaves.

It is better to give him the opportunity for ownership than to hand over a piece of the pie without any commitment on his part.

 

[MiketheEngineer]

I think it is time to talk to a lawyer well versed in these matters.... While I agree with what has been said, you are asking a bunch of engineers legal questions...for which we are definitely not qualified to answer.

 

[Ashereng]

It is common to have a "grace period" in the contract for new principles" coming into a company, whereby either party can "back out", with the stipulated conditions and payouts.

It is hard to determine if someone would "click" with your company, and even harder to determine if someone is worth the value. A grace period, or trying out period allows both sides to determine the fit, and should either want to back out, the provisions in the contract would provide for that.

"Do not worry about your problems with mathematics, I assure you mine are far greater."
Albert Einstein
Have you read FAQ731-376 to make the best use of Eng-Tips Forums?

 

[hydro10]

Thanks. I appreciate all these ideas, which helped to point me in the right direction.

I learned that first we need to have a valuation for our company, which could be performed by an "expensive" expert business consulting firm. The valuation process can be fairly complex because is based on projected revenues and profitability, but also a thorough market analysis of similar firms that were recently sold, business development marketing backlog, and other “intangibles” such as name recognition, and corporate culture.

A simple rule of thumb is to multiply our latest annual net income off our P&L statement by 3 to 5.

The next step after the valuation (i.e., knowing what my company is worth), is to develop the plan/contract for a time-structured buy-in with a cap on ownership. I welcome any advice about that.

I realize these are attorney/accountant type of questions. However, our firm is fairly small with annual gross revenues around $600K. I don't want to hire an attorney yet, since we're still only getting to know our potenital new principal. Besides, I'm less interested in what an attorney would say than what a principal engineer would want. Have any of you particpated in a structured buy-in? What worked? What didn't work?

The trial period is excellent advice. Thank you.

 

[Ron]

There are several ways to "value" a company. One is a multiplier on revenue (2 to 4x). Another is a multiplier on net asset value (6 to 10x), but not so great for service businesses that have few hard assets. In any case, keep in mind that owners tend to over-value their businesses while the market tends to under-value the business. One thing that is not usually given enough value is the "good will" of the company...essentially how it is viewed in the marketplace.

Any company is only worth what someone is willing to pay for it (that's pretty obvious)...however, few companies are actually on the market when they are "valued".....so valuations are somewhat "pie in the sky".

Good luck...I've been through it an it isn't fun!

 

[abusementpark]

a time-structured buy-in

An elementary question: How does this actually work? Is the individual literally paying money out of pocket to gain an ownership stake in the company?

 

[Ron]

abp....it can be structured any way the parties agree...for instance, let's say the new guy will have salary of $100k. He might actually take a salary of $85k and the other $15k goes to the buy-in. Another way is that he gets $100k in salary and has to buy the stock at a reduced value.

There are many ways to do it...just be sure it is equitable and repeatable for the future.

 

[casseopeia]

You probably ought to start off with a business valuation. It's a service that many business accountants and CPA's offer. As I recall, the valuation for a consulting firm is generally based on earnings times a multiplier, and not on fixed assets. The earnings is generally based on 'earnings before interest and taxes (EBIT)'. The multiplier in my case when I was bought out was about 3.

If you are a sub-chapter S corp, then you have stock. You simply divide the valuation by the number of shares and 'sell' shares to an incoming principal by any number of methods as Ron has suggested.

"Gorgeous hair is the best revenge." Ivana Trump

 

[rowingengineer]

A bit less than a year ago I purchased into a company as a principle. To do this they broke the company into a 100 shares and gave a calculated value to each share based on a scale bask approach to valuation based on the previous 3 years (ie last year’s returns x3, 2 years ago x2 and 3 years ago x1/a nominated number). I signed a contract such that I would own 10% than buy the rest after a year. To do this I had the choice of a loan at company rate, or pay by cash. At the same time they also allowed long term employee’s that they wished to retain into the future the chance to buy in.

ANY FOOL CAN DESIGN A STRUCTURE. IT TAKES AN ENGINEER TO DESIGN A CONNECTION.”

 

[abusementpark]

abp....it can be structured any way the parties agree...for instance, let's say the new guy will have salary of $100k. He might actually take a salary of $85k and the other $15k goes to the buy-in.

Based on this scenario, it sounds to me like it would be a while before one would reap any financial benefits of ownership.

 

[hydro10]

"Based on this scenario, it sounds to me like it would be a while before one would reap any financial benefits of ownership."

Yes, abusement park, it will take a while for a new principal to reap the benefits of ownership. Just as it took me 12 years to build the company to its present value (incl. cash on hand, accounts receivable, goodwill, and backlog of work). The first year I started the firm, my income dropped to 42% of what I'd earned the previous year as a principal level engineer (without ownership) in a similar small consulting firm.

I appreciate all of the advice everyone has provided. Excellent ideas! Thank you!

BTW, another former colleague suggested a phantom stock option for a potential key hire. The phantom stock is a much simpler way to share in the profitability of the company. It’s basically bonus plan without the formality of the stock options, but grants the key hire a stake in the appreciation of the company. Check out the link, which gives a more detailed description of phantom stock

http://www.nceo.org/main/article.php/id/43/

A lot to think about....

 

[abusementpark]

Yes, abusement park, it will take a while for a new principal to reap the benefits of ownership. Just as it took me 12 years to build the company to its present value (incl. cash on hand, accounts receivable, goodwill, and backlog of work). The first year I started the firm, my income dropped to 42% of what I'd earned the previous year as a principal level engineer (without ownership) in a similar small consulting firm.

Right, but that's why you and your partner are still going to retain the lion's share of the ownership.

I'm realize I am not looking at the whole picture here, but I assume the reason you want to make this guy a principal is because you anticipate he will add at least some significant value to your firm through his human capital. Wouldn't a small amount of ownership be justified on that basis alone?

 

[alehman]

Valuation of an engineering company can be tricky business. There are lawyers who specialize in this. Might be good to find one. This is something you need to get right.

Alan
“The engineer's first problem in any design situation is to discover what the problem really is.” Unk.

 

[glass99]

Privately held engineering firms typically change hands for about 3-5 times earnings, but publicly held firms tend to trade on the stock market for P/E ratios of about 15 (e.g. Michael Baker or URS).

I believe this accounts for part of the acquisition logic of monsters like AECOM.

 

[cvg]

At the same time, we do not want to give away the value of a company that we worked 12 years to build.

it would hardly make sense to hire a new principal if that person did not bring in any new business. So it also fair to offer ownership in the company. You should not feel that you are selling the company but rather the company should be growing and earnings for all stockholders should increase due to this new business. If this is not your expectation with this new hire, than don't make him a principal and don't give him ownership.

 

[pmadson]

At the end of the day, it will all come down to what you and the new Principal think is fair and reasonable. I "bought" into my firm by simply not taking a salary for several months. Our firm was only a year old, so we worked it out so that my "buy-in" would be about the same as I would spend (not earn)by starting up on my own. That also caused it to work out so that the other two partners kept the money that they had already made and we all split 3 ways the money that all 3 of us made combined after I joined.

That is probably too simple for a 12-year old firm.

But no matter what, make sure you discuss your plans with your accountant before you ink the deal so no one is surprised by the tax consequences.

Pete Madson

http://www.npcg.net