Many civil engineering firms, coming out of the worst of the economic downturn, have gone from peak earnings to losses and back to a modest profit. Such volatility in profitability can be a challenge from a valuation perspective, especially during an internal ownership transition. Many owners want to break down their firm's valuation into a simple Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) multiple. Besides an EBITDA multiple not being a true form of valuation, the issue is that when there is significant volatility in EBITDA, you are concerned about not only what an appropriate multiple is, but also what value of EBITDA to multiply against it.

Whether performed by an appraiser or as part of a valuation formula, the most common method used to smooth out volatility is three- to five-year simple or weighted average of EBITDA. The math is simple; however, the implication to an ownership transition is great. Depending on where your firm is in the economic cycle, the average EBITDA will either be higher or lower than your previous year's or trailing 12 month's results. If your earnings are at their peak, as a seller you want to have a shorter weighted average that puts the most emphasis on the peak year. If you are a buyer in this situation, you want to spread out the earnings to deemphasize the peak year.

The impact of the methodology of the transition is as important as how the firm will be valued. For instance, if a seller in a firm is prepared to sell 400 shares to a newly minted partner and is expecting a decline in the firm's fortunes, a financed purchase – a new owner buys shares and pays for them using a promissory note – will benefit the seller more than a series of yearly transactions that are paid for up front. If the value per share begins at $100 and declines every year by $5 per share, then the seller would clearly want to sell in a financed transaction.

Now that you have seen declining earnings, here is a comparison of increasing earnings where the price per share increases by 10 percent per annum. In an increasing earnings stream, the yearly purchase is better for the seller because the price per share is increasing faster than the coupon rate on the promissory note. The installment method is the least risky way to transition a firm; however, it is also the least utilized method by AEP and environmental firms.

If you are contemplating an internal transaction, the fairest method for both buyers and sellers is to hire an appraiser. Nevertheless, many firms do not want the added expense of a yearly appraisal for ownership transition purposes and choose a formulaic approach. Appraisers are not fortune tellers and an appraisal will not give you perfect information as to the future value of your firm; however, formulas are inherently backward looking and will not be able to use any information or data, such as the AIA Billings Index, construction-put-in-place forecasts, or equity index information. If you know you are about to drive off of a cliff, your formula is not going to reflect that in a value until you have already driven off the cliff; an appraisal will begin to adjust the value before the fall.

Whether an internal or external transaction, a buyer and seller must agree on a fair valuation and terms of sale. Often in an internal sale, the sellers make the decisions regarding the terms of a sale in a vacuum without input from the buyers. It can be tempting for sellers to choose a methodology that fits their best interest rather than what is best for the firm. Our industry is risky and volatile. Decisions regarding how to value your firm in an internal transaction should be made in a spirit of shared risks and rewards and not in a way that unfairly puts the risk of a transition solely on the shoulders of one group at the expense of another.

W Hobson Hogan, a principal at ZweigWhite, assists AEC firms with strategy formulation and ownership transfer issues, including buyer and seller representations. Contact him at hhogan@zweigwhite.com.