How do you finance the purchase of an engineering firm?

What the buyer is actually paying for

Buy a machine shop and you get machines. Buy an engineering firm and you get clients who trust a particular group of engineers, licenses held by individual people, a backlog of signed work, and some computers. Because nothing on the balance sheet would repay the debt in a liquidation, the credit rests on one question: will the firm keep earning what it earns now once the transaction closes?

Engineering and related professional services are an active market for private equity platforms and strategic acquirers, and firms at this size are also sold to their own principals or to an ESOP. Each buyer brings different equity, but lenders work through the same four questions in order: can the buyer lawfully own and operate the firm, who will do and sign the work, how much revenue is contracted and with whom, and how quickly that revenue becomes cash. A firm this size has usually outgrown SBA financing, whose 7(a) loans go up to $5 million.

Who is allowed to own the firm

Engineering is a licensed profession, and states regulate firms as well as people. A firm offering engineering services commonly needs its own certificate of authorization in each state it works in, and a licensed professional engineer in responsible charge of the work, the person who seals the drawings. Some states require that a share of the owners or directors be licensed engineers. The rules differ by state and entity type, and a buyer's counsel should confirm them in every state the firm practices before the letter of intent is signed.

For a strategic buyer that is itself an engineering firm, the answer is usually straightforward. For a financial sponsor, the structure has to satisfy each state: licensed engineers among the owners or directors where required, and staying principals named as the engineers in responsible charge. Lenders will not fund a firm that cannot lawfully offer its services the day after closing.

If one founder seals most of the firm's work, the license plan is the loan. Solve it before anything else.

Backlog, contracts and the clients behind them

Engineering revenue is project work, but often more repeatable than it looks. Public agencies hire firms under multi-year on-call or master agreements; developers and contractors return to engineers they trust; industrial clients keep firms on retainer. Lenders want the backlog, signed work not yet performed, and how much of each year's revenue came from clients who were also clients the year before.

Two points trip up engineering deals. Many contracts, particularly public ones, were awarded on the qualifications of named staff and may require the client's consent to an assignment or change of control; see change-of-control consents. And concentration: a firm whose largest client supplies 400 of every 1,000 of revenue carries a single-relationship risk, however good the client. Lenders size more conservatively and ask for more equity, rollover or seller financing. See customer concentration.

Unbilled work, slow payers and professional liability

Engineering firms carry a lot of cash inside working capital. Work is performed, billed at a milestone or month-end, then paid on the client's schedule, and public agencies can be slow. Some contracts hold retainage until close-out. A profitable firm can be short of cash, so lenders read the balance sheet as closely as the P&L, including the age of work in progress, work done but not yet billed. Unbilled work that has sat for months may reflect a dispute or scope the client will not pay for.

A revolver against receivables funds that gap. Asset-based lenders typically advance 80% to 90% of eligible receivables and treat invoices more than 90 days past invoice as ineligible; unbilled work generally supports little or nothing. The purchase agreement should settle who is paid for work in progress at closing; a working capital peg that includes receivables and unbilled work keeps the seller from collecting the cash while the buyer does the remaining work. See working capital at close.

An engineer can be sued over a design years after the project was built. Professional liability policies are usually claims-made, covering claims made while the policy is in force for work after a stated date. Buyer and seller must agree how past work stays covered, whether the firm's policy continues or an extended reporting period is bought. Lenders ask for the policy, claims history and open disputes; a pattern of claims around one type of work or one engineer is a credit question as well as a legal one. See asset vs stock purchase.

Structures that fit an engineering firm

The founder's transition deserves particular thought. Many buyers keep founders on through a transition with rollover equity or an earnout, which lenders welcome. But retention agreements for the next tier of engineers and project managers, signed before closing, often matter more to a lender than the founder's own arrangement, because they are the people clients will call in three years. For insider transactions see management buyouts and ESOP sales; for add-ons, financing add-on acquisitions. Lenders will also expect quality of earnings work that tests revenue recognition on long projects.

The documents an engineering lender asks for

For the term loan, lenders start with the P&L, the balance sheet and the debt schedule, with a year-to-date P&L and an AP aging where available. The revolver adds an AR aging by client with days outstanding. The acquisition adds the target's latest full year of figures for every company being bought, never an older year, and the letter of intent. For an engineering firm, add:

• Backlog by contract: client, type, remaining value, expected timing, and whether it needs consent to assign.
• Revenue by client for each of the last three years, showing repeat clients.
• A work-in-progress schedule with the age of unbilled work.
• A staff roster with roles, tenure, licenses held and who has agreed to stay.
• Certificates of authorization by state, and the engineers in responsible charge after closing.
• The professional liability policy, claims history and open disputes.

Senior bankers run every Midas Partners engagement. Once the documents are in, Midas Partners builds the financing model, lender presentation, blind teaser and underwriting memo in a day; built by hand the same package takes at least a week. Software does the analyst work and a senior banker checks every page before the client approves it. Lenders that fit see a blind teaser first, and the client approves each by name before it learns who the firm is. See the package.