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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
- 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.