Benchmark Report 2023: Looking Ahead—Succession Planning and Firm Value

By Elaine Pantel On Nov 8, 2023

In the Canadian Architectural Practices Benchmark Report, half of firms identified economic factors as one of the greatest challenges to the profession in the coming decade, followed by challenges related to workforce and human resources, at 34 percent. These two sets of issues intersect in succession planning, which is at the forefront of firm leaders’ strategy to build long-term value and generate sustainable growth and profitability for their firms.

A succession plan may include a number of avenues, which are not mutually exclusive:

Organic succession—building the next generation of firm leadership from the employee team;
Recruitment of external senior talent;
Acquisition/sale/merger of the firm.

This article focuses on the key elements of a well-planned organic succession plan, using Benchmark Report data to provide insights into firms’ approaches. Succession planning will focus on a firm’s revenues and profitability, as well as its culture, with the goal of creating a place that employees feel is worth a significant financial and personal investment. With only 41 percent of individual respondents rating their job satisfaction as 8 to 10 on a scale of 0-10, and just 50 percent pegging their work-life balance as an 8 to 10 on the same scale, there are clearly improvements available in making the prospect of firm ownership an attractive proposition for the next generation of leaders.

The pathway for employees to develop the skills to take on management and leadership roles is a long-term, multi-phase process. It is essential for firms to establish clarity regarding career advancement pathways, mentorship and education of employees who are identified as future leaders, and the use of bonuses and financial incentives to reward performance.

Career advancement

According to Canadian Architectural Practices Benchmark Report data, less than half of firms, across all sizes, have a succession plan or ownership opportunities in place. For those that don’t, it may be time to start. Among the firms I’ve advised, most firm owners have come to understand that the organic succession process needs to be considered much earlier than they had previously thought. Owners will need to be willing to admit new owners at some point in the firm’s development, and this may take time to develop. Furthermore, it may be years before an individual is ready to move into an ownership position. A “Pathway to Ownership” program will itself evolve over time. It is good practice to develop a document that outlines the process. Some of the key components of such a program may include:

Description of the firm’s culture, values, and vision for the future;
Progression of positions in the firm, with reference to a skills matrix;
Coaching and mentorship opportunities and programs;
Professional development in the areas of leadership and management;
Incentives, such as bonus structure and profit-sharing plan, as well as other perks.

Positions, functions and skills

The report lists over 15 staff categories that are currently in use by firms. This is an indication that firms are offering their employees an array of opportunities for career advancement. Although smaller firms have fewer categories, there is a clear progression to more senior roles. Notably, many larger firms are providing their Associates with management responsibilities. Within firms, the best practice is for each position category to be well defined, with a detailed skills matrix, to highlight what skills are needed to advance. Employee evaluations—formal and informal—should focus on skills development, milestones, goals and steps forward.

Bonus structures and profit-sharing plans

While just under half (49 percent) of firms of 3 to 10 people have a bonus structure, this grows to 73 percent in firms of over 11 people. Likewise, just 11 percent of 3-to-10-person firms have a profit-sharing plan; this grows to 20 percent of 11-to-25-person firms, and 26 percent of firms larger than 26 people.

Performance-based bonus structures and profit-sharing plans are effective incentives that can be used to reward performance and increase employee engagement in the years leading to a potential offer of ownership.

Bonus structures, which may or may not be based on the level of a firm’s profitability, may be offered by employee position or throughout the firm. Profit-sharing plans are generally used for more senior employee positions, and may be based on the firm’s overall financial performance, or the profitability of individual offices, business units, or service lines. In both scenarios, firm leaders need to determine the level of transparency, and how much of the firm’s financial information is to be shared with employees.

Financial literacy and understanding firm value

The sustainable growth of a firm is driven by consistent and healthy profits. It’s important for architects to understand how to make a connection between the design process, project management, and the financial results for the firm. This applies throughout the firm, with the level of understanding dependent on the position of each individual.

While the focus of owners is on short-term management and longer-term strategic planning, senior architects will ideally have a solid understanding of the efficiencies and profitability related to project management. Understanding how to read financial reports is critical, as this information provides valuable feedback to assist in planning and decision making. Project management software packages include the ability to design custom dashboards to be used throughout the firm—a feature that is underused by many firms.

There is a direct link between the firm’s financial performance and its value. The value of the firm—a key consideration for succession plans—can be determined in a number of ways, including hiring a Certified Business Valuator to provide a formal valuation, or using a formula based on the ongoing profitability of the firm. The former is costly and time consuming, whereas the latter can be developed and customized by firm leaders, with assistance from external advisors, and updated on a regular annual basis. In some cases, the value formula can be inserted in the firm’s ownership agreement.

External advisors can play a key role in developing an education program to increase financial literacy for firm leaders and management. Possible topics include:

Learning how to read Financial Statements, including differences between the Balance Sheet and Income Statement;
Understanding the difference between profitability and cash flow;
Understanding working capital, i.e., the amount of money the firm needs access to on an ongoing basis to fund operations;
Knowing what the firm’s profit margin is, and how to set targets;
Using budgets and forecasts for earnings and cash flows, and reviewing budget variances to update forecasts;
Setting and tracking “Key Performance Indicators” (KPIs) to benchmark the firm’s performance.

Ownership transfer

A well-planned organic succession plan includes several phases: Employee Assessment, Offer of Ownership, and Implementation. When embarking on an organic succession project, firm leaders will engage with a circle of external advisors with experience handling transactions in the architectural industry, such as a business consultant, financial and tax advisors, a lawyer, and an insurance specialist.

In the Employee Assessment phase, firm leaders will identify significant challenges facing the business in the next three to five years, critical positions that will be needed to support business and ownership continuity, and key competencies and skills needed for success. Next, they will identify a pool of talented and high-potential employees who will be coached and mentored to move into more senior roles through specific career development strategies and compensation incentives. These strategies and incentives would be detailed in the Pathway to Ownership program. An experienced business consultant can provide additional value to guide the firm through this phase. At the end of this phase, firm leaders will have identified a group of key employees to be presented with an Offer of Ownership.

The Offer of Ownership phase can be a lengthy process, as it involves a number of steps and is an organic process whereby the needs of sellers and buyers of ownership interests may change over time. This phase usually proceeds concurrently with the Employee Assessment phase. Firm leaders would engage with an external financial advisor, tax advisor, and lawyer at different points during this phase.

As a financial advisor, I have guided firm leaders through the following steps, collaborating with other advisors:

1 – Set the overall scope of the project and engage with firm leaders to discuss the firm’s succession strategy and owners’ long-term plans, review the current ownership structure and financial position, and consider the general plan to transfer ownership (percentage of the business to be sold, timeframe, and financing options). This includes the preparation of financial modelling of various scenarios for the transfer of ownership interests over time.

2 – Consider the valuation methodology and terms of the Offer of Ownership, and have a series of in-depth discussions with firm leaders on options for pricing ownership interests and how this relates to a consideration of the value of the firm. This includes the preparation of financial analysis of the firm’s performance over the past three to five years, including adjusted (normalized) earnings, base level of capital to be retained in the firm, and other factors. On occasion, I have been asked how other firms in the industry have set the pricing of ownership interests. There is a wide range of methods and approaches which are tailored to suit each firm’s unique culture regarding organic succession, as well as the needs of the sellers and buyers. As the Offer begins to take shape, cash flow models are prepared to illustrate the impact for sellers and buyers over an appropriate period of time. A tax advisor is engaged to provide guidance on the structure of the sale of ownership interests, including any pertinent tax considerations. At the completion of this step, firm leaders have agreed on the terms of the preliminary Offer of Ownership, although there may be iterations as the process continues.

3 – Prepare and present a Proposal and Offer of Ownership to key employees. The plan for the sale of ownership interests is presented to the key employees who have been identified in the Employee Assessment phase of the project. The initial presentation is coordinated by firm leaders and external advisors (business consultant, financial advisor and tax advisor). As this will be the first interaction presenting an Offer of Ownership to the employees, it is important to craft a narrative that illuminates the firm’s history and plans for the future. Financial information is then presented in a way that simplifies the firm’s financial position and valuation methodology, phased plan for the transfer of ownership, and cash flow models that illustrate the impact for buyers. An Executive Financial Dashboard is an excellent tool to be used in this process (refer to Sidebar). In a series of follow-up meetings, the details of the Offer will be discussed and employees’ (and their respective advisors’) questions and concerns addressed. During this period, various terms of the Offer may be revised. At the completion of this phase, the terms of the Offer have been finalized.

I have occasionally seen a general reticence on the part of some employees to take this important step in their careers. They may be concerned about making a long-term commitment with the firm, possibly taking on debt (depending on the pricing and financing mechanism), assuming risk as an owner, and the lack of clarity about how they will become involved in the management of the firm. All of these concerns need to be addressed in the series of meetings, and it is possible that not all of the selected employees will ultimately accept the Offer.

4 – In the Implementation phase, firm leaders will engage their corporate lawyers to draft the Ownership Agreement. This agreement covers many areas including the management of the firm, key decision-making, financing the firm, legal and financial terms for changes in ownership interests, and dispute resolution. Overall, there is a need to provide clarity to all owners regarding future transactions and to protect the interests of minority owners. Firm leaders may engage with their financial and tax advisors to review certain clauses of the agreement dealing with the buy-sell of ownership interests. Once the agreement has been completed, it is then passed to the employees’ lawyers for their consideration. There may be a number of amendments as the parties work through the agreement. Once agreement is reached, the lawyers will prepare all additional required documentation for review. The date for the finalization of the transaction will be set, and final preparations will be undertaken.

The implementation of the human resource aspect of the transaction will be an ongoing process of mentorship and skill development for the new owners, and the plan to integrate the new owners into the management of the firm will be set in motion.

Conclusion

The architecture profession is experiencing a period of significant change and shifts. Developments in the area of organic succession planning are focusing on success for all parties and the firm, augmenting personal satisfaction and firm value over the long term. It’s an exciting time, and there is much room for creativity and innovation in developing and evolving organic succession plans and ownership models for firms.

Elaine Pantel, CPA, CGA, ICD.D is a strategic advisor to leaders of Architecture, Engineering and Design (AED) firms, as an independent consultant. She is a former partner of a Toronto-based firm of Chartered Professional Accountants, where, over many years, she played a key role in developing and growing the firm’s vibrant AED industry client practice, helping clients achieve success. Elaine has provided educational presentations to clients and industry members as well as the OAA, OALA, IIDEX and SDA Canada.

Executive Financial Dashboard

A customized Executive Financial Dashboard of KPIs can be used to align with strategy, assess and monitor the financial health of the firm, manage day-to-day operations, and set performance targets. The Dashboard is also useful in organic succession planning, to communicate summarized financial information to key employees who have been presented with an Offer of Ownership.

The Dashboard is intended to be a “living” tool that is reviewed and referred to on a regular basis (eg. quarterly, semi-annually or annually). By assessing the firm’s performance over time, firm leaders can identify areas in which changes are occurring, and assist in strategic planning, risk management and operational decision making. The Dashboard can also be used for comparison with industry trends. Ideally, the Dashboard should be concise—one to two pages—to allow leaders to focus on critical metrics.

The Dashboard can be designed to link to data from the firm’s Financial Statements, creating more clarity about the firm’s financials for individuals at different levels of responsibility.

Here are some KPIs that I suggest to clients for inclusion in an Executive Financial Dashboard:

Balance Sheet KPIs focus on the billing cycle and overall financial position of the firm:

Days Aging in Accounts Receivable: average Accounts Receivable x #days / Gross Fees
Days Aging in Work in Progress: Work in Progress x #days / Gross Fees
Current Ratio (liquidity): Current Assets / Current Liabilities
Debt to Equity Ratio (liquidity): Total Liabilities / Shareholders or Partnership Equity

Income Statement KPIs focus on performance and efficiency:

Net Fee Multiplier: Net Fees / Total Professional Labour
Net Fees per Full Time Equivalent (FTE): Net Fees / Full-time Equivalent employees
Overhead Rate: Total Overhead / Total Professional Labour
Profit on Net Fees (also known as Operating Profit Margin): Pre-tax earnings / Net Fees
Utilization Rate: Hours spent by professional staff on projects / Total hours worked
Key Costs as a percentage of Net Fees

Note: In his article “How is Your Firm’s Financial Health,” Rick Linley takes a deep dive into two key metrics: Net Fees per Full Time Equivalent and Operating Profit Margin, and provides profiles of firms that are evaluated to be Struggling, Strong and Super.

Predictive KPIs set the groundwork for budgets and forecasts: