Punching Out! What the Heck is Adjusted EBITDA?

Reading time ( words)

If you are looking to sell or buy a business, you will most likely come across the term ‘adjusted EBITDA.’  Other common terms are adjusted cash flow, owner’s discretionary earnings, earnings after add-backs, etc. What do these terms mean, and why are they important?

EBITDA is an acronym for earnings before interest, taxes (on income), depreciation and amortization. The purpose of using this equation is to help evaluate a company independent of several variable factors. It does not mean that buyers will disregard depreciation, interest or taxes, but it is a way to try to compare apples to apples. It is a commonly accepted principle in investment banking, but the interpretation of the adjustments is always up for debate.

Adjustments are used to help normalize a business’ earnings as if the company were run on a neutral basis. One of the most common adjustments is owners’ compensation, as many owners pay themselves more salary than they would pay a replacement. For example, if an owner is collecting $250,000 a year in salary, but the market rate to find a President or General Manager to run the shop would be $150,000, the difference can be added to adjusted EBITDA. If an owner is not involved at all in the business, we might argue that all owner’s compensation can be added back. Conversely, if the owner is not receiving a market rate, or just receiving distributions or dividends, a market rate salary may be deducted from adjusted EBITDA.

Other common adjustments are:

  • Rent: if the company owns the building and does not charge itself rent, or if a related third party owns the building and charges below or above-market rent.
  • Personal Expenses: this could be vacations to Cancun, or it could be owner’s expenses that a buyer might not continue, such as first-class plane tickets to a trade show instead of economy.
  • Company Cars: this might be a luxury that a typical buyer may not continue.
  • Owner’s Medical and Life Insurance: the owner may have Cadillac plans, key-person insurance, etc.
  • One-Time Expenses: this often includes consulting fees (including investment banking and legal fees), major restructuring fees, bad debts (if a one-time event), etc. Any extraordinary income will reduce earnings.
  • Bonuses: any excessive bonuses or salaries paid. However, this has to be a one-time event, such as severance pay. If the bonuses or salaries will continue after the business is sold, it is not easy to add these expenses back.
  • Family Member Compensation: Some businesses pay family members who do not actually work in the business, or above-market rates. These can be added to EBITDA if the practice will not continue.

Although it might be tempting for an owner to add everything back but the kitchen sink, I believe it is important to keep things reasonable. A buyer will be turned off if there are too many adjustments, and multiple small adjustments can leave the impression that the owner may be prone to over-negotiate or is unreasonable. You do not want to start off on the wrong foot.

Some of the items that can reduce a buyer’s assessment of a business are under-investment in equipment or people. For example, if a shop has not invested in new equipment for 5 years, a buyer may reduce their offer to make up for the lack of investment. Also, if it appears that the owner has not been investing in training, or has not been paying for health insurance, 401K, etc., that might cause the buyer to add expenses to their assessment of the business.

Here is an example of typical adjustments:

  • Net Income: $500,000

Plus Add-backs:

  • Taxes: $250,000
  • Interest: $25,000
  • Depreciation: $100,000
  • Owner’s Compensation: $100,000 (Actual Salary $250,000, less market rate of $150,000)
  • Rent: $50,000 (Actual Rent $150,000, less market rate of $100,000)
  • Travel and Entertainment: $5,000 (Discretionary expenses)

Total Add-backs: $530,000

Total Adjusted EBITDA: $1,030,000

Add-backs can substantially change the valuation of a business. If companies are selling for 4−5 times adjusted EBITDA, the difference between Net Income of $500,000 and adjusted EBITDA of over $1 million is quite a bit.

If you are thinking of selling a business, the adjusted EBITDA number is good to have available. Your CPA can help you calculate this, and it is common for investment bankers to help calculate and assess the feasibility of the adjustments. Most buyers will obtain an independent review of earnings, so any adjustments will need to be justified. A well-documented adjusted EBITDA calculation shows that an owner is prepared, knowledgeable, and reasonable.

Buyers review a wide range of factors when assessing a business, and adjusted EBITDA is just one of those factors. A company may have positive adjusted EBITDA, but negative cash flow (or vice versa), so it is important to understand the business’ working capital, capital expenditures, and other factors. Even if a buyer and seller agree on the calculation of adjusted EBITDA, they may not agree on the earnings multiple used to calculate valuation, and then we still need to agree on terms and conditions.

Tom Kastner is a Senior M&A Advisor for Woodbridge International, a global investment bank, and the President of GP Ventures, a tech-focused M&A advisory firm. To contact Kastner, click here.


Suggested Items

Catching Up With Author Michael Kurland

10/03/2022 | Dan Beaulieu, D.B. Management Group
"Broken to Better: 13 Ways Not to fail at Life and Leadership" is simply one of the best books I’ve read this year. In fact, I was so impressed that I decided to reach out to the author, Michael Kurland, to talk about his book, what led him to write it, and what we should all learn from it. Michael was gracious enough to take time out of his busy schedule to share his thoughts on building his business and why he wrote a book about it. I think you will find it provocative and thought provoking.

I-Connect007 Editor’s Choice: Five Must-Reads for the Week

07/08/2022 | Nolan Johnson, I-Connect007
In more than one conversation while discussing the industry this week, the themes have included industry turmoil, lots of business opportunities, and the urgent need to build out to meet changing demands. In fact, our July issue of PCB007 Magazine, which publishes later this month, will focus on these very topics. It’s definitely one not to be missed! These themes also emerged in this week’s top five news items as well. Top stories include an acquisition in the soldering machinery space, sales and service expansion in Mexico, industry data from SIA on semiconductor global sales data, and strong financial numbers from two China-based manufacturers. Now, with the U.S. Congress putting its focus on the PCB industry, things could really heat up. It’s going to be an interesting year.

Catching up With Author Ed Chambliss: Fixing a ‘Broken’ Business Model

06/22/2022 | Dan Beaulieu, D.B. Management Group
I love books, especially good business books. In fact, I read three or four a week which I believe makes me a very discerning critic when it comes to ones with the right message. "A One-Legged Stool: How Shareholder Primacy Has Broken Business (And What We Can Do About It)" by Ed Chambliss is one that can help us in both business and life. It has the right message. This book is so timely and extremely important now because Chambliss brings to light one of the great wrongs in the thinking of the last century, an error that has broken business for the past 50 years—the idea that we are all in business to make money for our shareholders and (and all others, employees, customers, and vendors be damned). We all know where this has gotten us.

Copyright © 2022 I-Connect007 | IPC Publishing Group Inc. All rights reserved.