What is Risky?
Mar 13, 1995
I am continually reminded of the bizarre sense of risk some principals in A/E/P and environmental firms have. I am talking about the obsession so many principals seem to have about extracting as much as they can from their professional service firm so they can invest it in something else— whether it’s real estate, another business, or publicly traded securities. What is strange is that they are draining their companies and investing in other things because that is supposed to reduce their risk.
This thinking comes from two sources. First, the principal probably learned it years ago from his or her mentor— most likely an older principal who ended his career by essentially giving his firm ownership away because he wanted to have an internal ownership transition. If that’s your idea of what happens when you cross the finish line, it’s not hard to understand why these principals might think the firm is only worth what they can extract from it each year. This was reinforced by the liability scare of the early 1980s (circa the Kansas City Hyatt Regency disaster), when no one wanted to have any money in their firm where some lawyer could go after it.
Accountants and attorneys are the second source in perpetuating this concept, and today, they are the main culprits. Most accountants (not all) have built no value in their own companies. They don’t like to retain earnings because they might have to pay some of it out in taxes. And they don’t, as a group, build companies because they never invest in the company— they just harvest. Short-term profits are the only way they measure a company’s financial performance. The fact is, equity growth in your firm may be as important or more important to your long-term financial security than short-term profit extractions. Not to mention that engineers and architects are notorious for making bad investments with short-term profit extractions.
Whether it’s real estate, another business, or publicly traded securities, these investments are usually riskier than running a business you fully understand— one you have proven can be successful. It’s extremely rare for owners of A/E/P or environmental firms to lose their shirts over risks they took in the operation of their firms. I won’t say it never happens, because it does— occasionally. But for every one example of a firm whose principals got themselves into financial hot water due to risks they encountered in running their firm (i.e., professional liability issues, reckless expansion, etc.), there are about 20 examples of principals who got into trouble with other investments. And many times, the problems associated with those poor investments translate into problems for the firm— especially in smaller firms or ones that have only one or a few major shareholders— which an outside observer might incorrectly associate with risks of this business.
Real estate is at the top of the list of risky investments for A/E/P and environmental firms. A lot of people have gotten rich from investing in real estate, but many have lost a pile of money in real estate, too. We’ve seen many cases of upside-down equity in real estate owned by A/E/P firms and their principals.
Other businesses that design or environmental professionals don’t understand can be risky and cost them a lot of money. We have seen clients lose money in a wide range of non-A/E/P or environmental firm ventures— including everything from candy stores to cattle farms to baseball card vending machines.
The stock market is another area that may cause trouble for firm principals. Wall Street is great if you aren’t looking for short-term returns and you have adequate time to study the market. If not, there will always be someone who knows more than you do about what to buy and sell.
Keep the following points in mind when you’re deciding whether to invest in your company or somewhere else:
There is value in the firm. The average firm is worth 40% to 60% of Net Service Revenue. And value to an outside buyer is impacted less by balance sheet and profitability issues than it is by volume.
What you can get out of the firm is directly related to what you leave in. You cannot have your cake and eat it, too. If you want long-term, sustainable high profits, you’ll have to invest in marketing, systems, and people. That takes sacrifices in short-term profits (which could be extracted for other “less risky” investments).
The return on equity for the typical firm is good. Not many investments that aren’t high-risk can produce a steady 20% or 30% or 40% return on equity. Yet many A/E/P and environmental firms do this (or better).
So next time your mentor or a small-minded outside advisor encourages you to extract all the money you can from your A/E/P or environmental firm in the name of reducing your risk, think long and hard about it before you heed their advice.
Originally published 3/13/1995
About Zweig Group
Zweig Group, three times on the Inc. 500/5000 list, is the industry leader and premiere authority in AEC firm management and marketing, the go-to source for data and research, and the leading provider of customized learning and training. Zweig Group exists to help AEC firms succeed in a complicated and challenging marketplace through services that include: Mergers & Acquisitions, Strategic Planning, Valuation, Executive Search, Board of Director Services, Ownership Transition, Marketing & Branding, and Business Development Training. The firm has offices in Dallas and Fayetteville, Arkansas.