Engineering Services M&A – Key Value Drivers and Performance Metrics

Updated on: September 10, 2019

The engineering services sector has experienced a significant ramp up in M&A activity over the past several years. This increased deal activity, as discussed in our industry outlook, is expected to continue for the foreseeable future and is the result of several factors ranging from increased competition, succession planning, and overall favorable economic conditions.

In order to increase attractiveness to potential buyers and maximize valuation in a transaction, it is important for engineering services firms considering a sale to understand different types of potential buyers and the key value drivers that are important to those buyers.

Who are the buyers and what are they looking for?
Active buyers in this space include both private equity firms and large strategic acquirers. Many Private Equity buyers are seeking to acquire new portfolio platform companies that will be the foundation for future acquisitions.  Strategic buyers (including private equity backed strategics) typically look toward M&A to effect growth in key strategic areas which may include growth in their service offerings, client base and/or geographic footprint.

Regardless of the rational for acquisition, both financial (private equity) and strategic buyers evaluate potential engineering services firms for acquisition based on a combination of key performance indicators (KPIs), several of the most common are outlined below:

Net Labor Multiplier
Buyer’s Preferred Range for Acquisition Targets: 3.00x to 3.25x
Net labor multiplier is a measurement of a firm’s return on investment for money spent on direct labor.  It calculates how many dollars of revenue are generated for every $1 spent on direct labor and is an indicator of how well a firm is managing its labor costs.  For example, if a firm has a net labor multiplier of 3.0x and an employee’s direct labor cost is $50,000, the firm is generating $150,000 in revenue from that employee’s direct cost.  Net labor multiplier can also be calculated on a project by project basis and is often used as a guideline for firms as they respond to RFPs.

Utilization Rate
Buyer’s Preferred Range for Acquisition Targets: 70% – 80%
Utilization rate measures the percentage of total labor charged to billable projects.  It is an indicator of how well employees are performing and if staffing levels are adequate.  Small engineering firms generally have higher utilization rates than larger firms, but all firms should closely track increases in employee turnover and the effects of new employee onboarding as these can have a negative impact on utilization.

Overhead Rate
Buyer’s Preferred Range for Acquisition Targets: 75% to 125%
Overhead rate shows the relationship between a firm’s non-billable/indirect expenses to billable/direct expenses.  It is an important metric for engineering services firms to track, and it is critical that executives understand the components of their firm’s overhead costs.  An increasing overhead rate can be due to a number of positive factors, such as investments in the business and employees, but can also be related to overall increasing costs in office space or general business expense growth.  Executives should closely monitor changes in overhead, as an increasing rate can have a major downstream impact on a firm’s overall financial performance.

Breakeven Rate
Buyer’s Preferred Range for Acquisition Targets: 175% to 225%
The breakeven rate is the total cost of doing business for every dollar spent on direct labor. It can also be thought of as the amount of revenue required to break even on the cost of a person’s employment, given their direct and indirect cost.  This is an important metric to consider when developing project fee budgets.  To determine each employee’s billing rate, simply add desired profit to the employee’s breakeven rate.

Total Payroll Multiplier (or Revenue Factor)
Buyer’s Preferred Range for Acquisition Targets: 2.0x to 2.5x
Total payroll multiplier (also called revenue factor) is an important measure of an engineering services firm’s operating performance because it directly shows how efficiently a firm converts labor to revenue.  This KPI tells us how many revenue dollars are being generated for every $1 spent on direct and indirect labor.

Buyer’s Preference for Acquisition Targets: 20%+
EBITDA margin is a profitability ratio that excludes company specific effects of taxes and financing decisions, allowing an acquirer to evaluate the profitability of acquisition targets on an apples to apples basis.  It is a measure of overall operational efficiency, pricing strategy and how well a firm is managing its projects.

While the quantitative KPI’s noted above are key factors affecting any buyer’s valuation of and appetite for a potential acquisition target, there are many additional qualitative factors that are also important to buyers when evaluating an acquisition, including overall size/scale of a target, customer concentration, and specific geographies served, and capabilities offered. An experienced investment banker can help a seller reconcile both the quantitative and qualitative factors to understand the seller’s potential options in a transaction.

SC&H Capital has completed numerous transactions in the engineering services industry and understands these factors, and how to position a firm for sale in this space.  If you are considering a sale, or have been approached by a buyer, we encourage you to Contact Us in order to guide you through this process.

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