The Ownership Mirage

August 1, 2001 · by Kerry Harding

This first in a two-part series on ownership transition highlights the driving forces behind the quest for ownership and how alternative solutions may be better for all parties concerned.

Ownership. It’s the buzzword of the “oughts” as this decade has come to be known. From the recruiter’s perspective, young staffers seeking a change of venue or promotion are putting it squarely on the table as part of the negotiations. First generation owners, faced with the growth of the last decade, are looking for ways to delegate more responsibility as well as convert sweat equity into a profitable retirement program.

In reality, it may be that, while the “greener grass” of a professional marriage seems appealing, once the ramifications are completely understood by one or both sides, simply a long-term dating relationship may be more appropriate.

What are the preconceived notions and misconceptions that are most often the source of problems in the early phases of ownership transition planning? That depends on which side of the table you’re on.

From the owner’s side, there are several issues, which may have not been carefully thought through. Prospective owners of a business anticipate and expect several new rights, which the founder(s) may not be ready and/or willing to grant just yet. What are the most common ones?

A seat at the decision making table. Every firm has (or should have) regular management meetings where the leadership team discusses staffing, cash flow, business development, and scheduling issues as well as the allocation of resources for technology, expansion and performance rewards. Prospective owners want to be informed in advance of key decisions that will affect them immediately or long term and to voice their approval or disapproval.

Involvement in planning for the firm’s future. “Control over my own destiny” ranks high among the perceived perks of ownership. What market sectors and/or clients to pursue; what benefits the firm will offer; changing the geographic reach of the firm’s practice; adding a new discipline or practice area; whether to acquire, be acquired or merge with another firm—these are just a few of the decisions made in closed-door planning sessions in which prospective owners want to participate.

Full access to key financial records. In every firm with which we’ve ever worked, there are two misconceptions which most frequently exist: it costs less to run the firm than it really does and the owners of the firm make a disproportionately higher amount of money. Depending on the firm, clear financial disclosure can be a wake up call as to the firm’s precarious financial position due to ineffective project management, account receivables collection and backlog burn rate. On the other hand, it can reveal that the owner(s) is (are) really compensated at a rate far exceeding their wildest imagination and create disgruntlement. In one western firm of approximately 60 people, the president’s total compensation was around $750,000. In another well-run 55 person firm in the Midwest, the president’s compensation package was over $900,000—about $700,000 higher than his non-owner principals had estimated.

A bigger share of the profit pie. The feeling exists, and rightly so, that, if you are an owner, you will make more money. Base salaries, end of year bonuses, retirement contributions and other perks with definite monetary value are the case in firms with typical financial performance in a growing economy. However, what most prospective owners don’t realize is that, for owners, the reverse can sometimes be true. In one very large firm with a lot of work but cash flow problems, principals were issued paychecks but told not to cash them until authorized and their bonuses foregone so that the staff could receive theirs.

Their name prominently (or at least legally) associated with the firm. Becoming a name partner or at least a legal one carries with in the connotation of having made it and being able to finally coast a little. What most prospective owners don’t understand is the downside. In one small Washington, DC firm, the $2.3 million dollar fee on a fixed-fee college facility was used up before the firm entered the construction document phase. To avoid being sued for breach of contract, the four principals had to mortgage their homes and provide $400,000 each to fund the project’s completion. In another case, a negligence lawsuit named all of the owners individually, as did a sexual harassment lawsuit when the principals of a firm declined to fire the offender among their ranks.

For most prospective owners, once the above “list of demands” is met, they don’t think there are any other issues that need to be addressed. This is where the contention begins. Before implementing a first generation transition of ownership, and, to a certain extent, successive generations as well, the existing owner(s) must ponder several questions:

How much is the firm worth? There are at least a dozen different ways that firm value can be calculated and, the end figures will vary widely depending on whether the valuation is done by an accountant, attorney or management consultant, as well as the timing of accounts receivables, backlog, tax payments and incentive distributions.

How much of the company do I (we) want to give up? Some firms elect to maintain a substantial amount of treasury stock to provide future flexibility while others simply allocate a portion of the original block of shares (normally 1,000) for distribution. Some owners want to ensure that, should the scenario arise where all other stockholders vote against him/her on an issue, he/she will still have a controlling interest. In some cases, the amount of stock that can be offered is limited by minority business enterprise (MBE) or woman business enterprise (WBE) stipulations.

To whom do I (we) want to offer ownership? Here is where the strategies diverge. Is it to acknowledge the “next generation” by a retiring owner or group of owners? Reward loyal, hard-working employees for outstanding service? A carrot to retain highly-recruitable employees? Regardless of why a particular group is selected, the most disastrous consequence is the inevitable omission of individuals who feel shunned and begin looking for other career opportunities.

What will be the rights and responsibilities of ownership? What will their titles be? Will they sit on the Board of Directors? Will there be additional perks such as a car, more life insurance, a bigger 401(k) match or another week of vacation? What new tasks and duties will they now have? Mandatory participation in one or more civic, professional or philanthropic organizations? Business development quotas? Staff recruiting and mentoring?

How should the ownership stake(s) be financed? Most prospective owners assume that design firm ownership is much like the grace-and-favor residences bestowed by the English kings and will be bestowed as a gift in recognition of past performance. Frequently, when they find out that they will have to pay for stock, they’re hurt or worse, outraged. However, if there is one thing management consultants to the design professions agree on it’s that prospective owners should feel that they are actually paying for a part of the company—that what they are getting actually has a definite financial value.

These issues are all background to those that surface when actually implementing the plan. The adage says, “From whom much is given, much is required,” and design firm ownership is no different. Many, if not most firms, require that, as part of ownership, employees sign restrictive employment and confidentiality agreements with clauses about non-compete, non-disclosure and other issues. This is where, as the saying goes, “The rubber meets the road.” Either a prospective owner is with you for the long haul—or they’re not. Asking them to sign agreements of this type will simply force the issue and you’ll find which camp they’re in sooner than later.

With all of these issues, what’s an owner to do? The first thing is to recognize that the answer to the question “Is ownership for everybody?” is always “no” or at least, “not right now.” Whether staff members realize it or not, ownership is accompanied by increased risk, sacrifice and obligation—with the potential (but not guarantee) of greater rewards. Some people understand this and are willing to bill their 40 hours a week in addition to spending 20-40 hours a week involved in non-billable endeavors like mentoring, marketing, recruiting and planning. Others would much prefer to work nine-to-five and sleep well, unencumbered by late night worries of meeting payroll, winning new work or solving interpersonal squabbles.

The real question is “what is it that prospective owners want?” If, as it was for one Midwest firm considering its first transfer of ownership, all senior staff really wanted was increased compensation, then the development of an incentive compensation program may be the better solution. It may come as a surprise to some but while architectural giant Leo A Daly Intl. is still entirely owned by the Daly family, it has in place a highly-detailed incentive compensation program. With a combined staff in 17 offices of around 900, Leo recognized early on that people could be well compensated and involved in the firm’s day-to-day management without having to be owners—they could be motivated, as the best-selling book says, to “act like an owner.” He once commented that most people would be better off to take their bonuses and invest them in the stock market than in an architectural firm.

That is not to say that a firm doesn’t need a succession plan. What happens to a firm and its employees if/when the owner(s) retire, die or become incapacitated has substantial consequences on its survival from both tax and legal fronts. An appropriate plan should be put in place long before it’s needed to not only ensure that a grieving spouse or executor of an estate is not put into the position of second-guessing what the owner would have wanted, but that the firm continues to fulfill the founder(s) mission by those people whom he/she would have wanted.

Like in all other aspects of management, open and honest communication in the early stages of the transition process will eliminate surprises and unmet expectations down the road and ensure that the needs of both sides—emotional and financial—are clearly understood and met.

The real challenge though is that, at it’s core, ownership transition starts as a recruitment issue. Firms should strive in every way possible to fill the aisles with people who, regardless of their status, “act like an owner” in everything they do—that their actions are guided by the simple philosophy of “is this in the company’s best interest?” Once that type of person pervades the culture, the thorny issues surrounding ownership transition will diminish and the firm will find itself generating sufficient growth opportunities to sustain it for years to come.

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