We recently completed a benchmark study on how architecture firms are handling the ownership succession process involving one or more founders who are near the end of their tenure.

The greatest misunderstanding occurs when the shareholder agreement does not specify how firm value will be calculated, and when a principal must divest his ownership interest.

The nine firms were located all over the U.S. (Northeast, Southeast, Southwest, Midwest, Northwest, West), and ranged in size from 25 to 190. Half of the firms had a single office, and the others had multiple offices.

Eight of the 9 participating firms are recipients of AIA National Firm of the Year Award, and the ninth received a regional AIA Firm of the Year Award. What these firms had most in common was a high quality design orientation. We call these Design-First Firms.

We selected the firms to be included in the research based also on their having one or more founders who were in process of stepping back—or had recently done so. What accommodation, if any, was made for the founder(s)?

Among the questions we asked were:

1. How many owners do you have?

2. Do the principals share ownership equally?

3. How many owners are not principals?

4. How have incoming shareholders bought in? For example, were they bonused the value of their shares, or did they bring outside investment to it?

5. How have retiring shareholders sold their ownership interest?

6. Were unique arrangements made for the founders of the practice?

There were some important conclusions from this research.

Lesson #1 – Make terms of ownership succession clear

The greatest misunderstanding occurs when the firm’s shareholder or partnership agreement does not specify how the value of the company will be calculated, and at what point in a career a principal/partner must divest his ownership interest.

In the firms we met with, arriving at an agreed-on value for the business was usually resolved with minimal friction. There are accepted methodologies for determining the value of an architecture firm, and principals can usually agree on one of those methodologies. This reduces potentially conflicting expectations, where a selling owner has an unrealistic view of the worth of the firm.

However, several of the firms in our research group did not clearly spell out at what point the partner/principal must start to sell down. Only four defined in their business documents a mandatory trigger date (or age) and a timetable for divestiture. That meant that, for those firms who did not define a threshold age for starting to sell, their only way to proceed was to raise the subject with their aging partners.

Such a conversation can easily escalate to an emotionally charged situation. Architects, who often practice well into their later years, can ignore the pleas of fellow principals and hold onto their ownership beyond conventional retirement age. Founding partners, in particular, often have an emotional investment in their firms that is hard to let go.

Clearly, the lesson from these firms’ experience is to make sure that the business documents are specific about when divestiture needs to begin and complete.

Lesson #2 – Avoid cutting unique deals

In some firms the terms of their ownership agreements were ignored for the founder(s) who were near retirement. Some allowed the founder(s) to stay an owner long after the traditional age where a principal would be required to sell. In one firm, as time passed this special deal backfired when the founder was no longer performing at a high level due to age and declining abilities. This, in turn, led to strained relationships, resentment, and difficult conversations.

The lesson to be learned: stick to the terms of the ownership agreement; no special deals out of sentimentality toward beloved founders.

Lesson #3 – Have a role of the partner after divestiture

A principal/partner need not exit the firm after completing the divestiture of his ownership stake. Indeed, these individuals embody wisdom and experience that can be of great value to those who continue the practice. Common transition roles are to be an external ambassador for the practice, and to mentor the next generation leaders. In our research we found that those firms who found a meaningful transition role for the founder benefited not only from his ongoing contribution but also from the outgoing founder’s sense of continued worth.

Lesson #4 – Pay attention to profitability; it finances the transition

One aspect of the research was to understand how new owners buy into their firms. In all but two of the nine Design-First firms, incoming principals/partners were awarded bonuses to cover the initial costs of buy-in. This is consistent with what we see around the country in consulting to architects, engineers and planners on their ownership transitions. Most design firms are not compensating their people at high enough levels to build net worth that would allow them to bring their own money to invest in the firm.

However, in two cases incoming owners were required to bring outside money to the first year’s buy-in. The rationale was to make sure that new principals had ‘skin-in-the-game,’ that is, were taking the business risk along with the others.

The clear lesson is, even a design-oriented firm cannot ignore the importance of being profitable. Indeed, profitability is required in order for an internal ownership transfer to be funded.

Lesson #5 – Be prepared to punt

In good times, the valuations of design firms may increase. As they do, the cost to buy in can become prohibitively expensive. In such situations, the owners are faced with the dilemma of whether to alter the terms of purchase to make it affordable for an internal transition; or to seek an outside buyer.

For Design-First firms, selling the firm externally is often contrary to their values: protecting the legacy is important. So taking another approach is paramount.

Among the nine Design-First firms in our research, two modified the buy-in terms by discounting the cost to buy in by as much as 50%. This accomplished the goal of continuing the practice through internal succession.

Lesson to be learned: be clear about the values underlying the practice. For these firms that meant staying independently owned.

What about your own situation?

If you’re just thinking about a future transition of leadership and ownership, here is our advice:

1. Start early; it takes more time than you would expect to effect a smooth internal transition.

2. When evaluating staff for potential leadership, assess their ability to generate new business; that’s even more important than their strength as designers or managers.

3. Loyalty of long-time employees should be appreciated, but not automatically rewarded with ownership in the firm.

4. Have a person who is experienced in A/E transactions determine the value of your firm—not your local CPA who has valued other kinds of businesses. They aren’t remotely similar.

5. Lay out the divestiture and buy-in schedule so that the payments to outgoing owners don’t weaken the firm’s financial stability.

6. Get coaching for yourself, to develop new behavior patterns of letting go and allowing others to lead.