LUTZ BUSINESS INSIGHTS
Understanding EBITDA and Normalizing Adjustments
In assessing how to value a lower middle-market business, buyers will typically focus on Adjusted EBITDA as their primary metric. Many sellers incorrectly believe that bottom-line net income and/or balance sheet asset values are what drive valuations, but this is rarely the case unless there are unusual circumstances that would require such an approach. Buyers will instead start with reported EBITDA, before making various normalizing adjustments (“add-backs”) to arrive at Adjusted EBITDA. Buyers would then apply a multiple to this Adjusted EBITDA figure to arrive at a valuation. Simple enough in theory, but we believe it is crucially important that sellers understand this calculation since it directly impacts valuation (and it is very often heavily negotiated during a transaction).
To define the term, EBITDA is Earnings before Interest, Taxes, Depreciation and Amortization. This figure can be readily calculated from the financial statements. Specifically, EBITDA is calculated as: Operating Income + Depreciation + Amortization. The Operating Income figure can be found on the income statement, while Depreciation and Amortization expenses are located on the statement of cash flows. It is important to note that Operating Income is not to be confused with Revenue or bottom-line Net Income. Operating Income is derived as follows: Revenue – COGS – SG&A Expenses. Note that Operating Income excludes taxes, interest, and other non-operating items because they are deemed to be non-core to the business. By adding back Depreciation and Amortization from the statement of cash flows, we arrive at EBITDA as a proxy for a company’s cash earnings. While not perfect, EBITDA is a widely accepted valuation metric.
Why do M&A practitioners use EBITDA for valuation purposes? Because they are trying to determine earnings power on a “going concern” basis irrespective of taxation and financing factors (i.e., tax and interest expenses are excluded from EBITDA). Because each buyer will have their own unique financing and tax situations, these items are not taken into account to derive a base valuation. This approach ensures that all buyers utilize an apples-to-apples valuation approach when submitting offers. Granted, buyers will consider their own specific tax and financing issues, but these are controllable and not relevant to the business under current ownership. This approach is somewhat similar to buying a home, whereby buyers will pay market value irrespective of their own unique financing and tax situations. The only way these issues come into play for a seller is if they affect how much a buyer can ultimately pay, but they should not impact the value of the underlying business. All else being equal, a buyer that utilizes debt and leverage would likely pay a higher multiple than an all-cash buyer because returns on equity would be enhanced via debt – but that’s a topic we’ll address on another day.
After calculating EBITDA, buyers will then apply various normalizing adjustments and add-backs to EBITDA in order to arrive at Adjusted EBITDA. Determining these adjustments is critically important because it goes directly to what a buyer will likely pay for the business. In a nutshell, these adjustments reflect expense items that are currently running through the income statement (and therefore included in reported EBITDA), but which will not continue to be expensed post-transaction. So, the Adjusted EBITDA figure is a proxy for what a likely earnings stream will be going forward. If certain expense items will cease after the deal, they are assumed to be zero in the future (thus, they are added back to EBITDA). A common example of this would be an owner’s personal expenses that are running through the income statement. We discuss the more common add-backs in detail below.
In the lower middle-market (transactions of $5 to $50 million, as we define it), a seller can assume 4-7x Adjusted EBITDA is a common valuation range (depending on a wide range of company-specific, financial, industry, and market variables). A seller can and should discuss an expected valuation multiple with its M&A advisor before going to market. Knowing this, a seller can easily determine how its business value would vary based on the magnitude and dollar amount of add-backs and adjustments. For example, including a $50,000 add-back for a one-time marketing expenditure could add perhaps $250,000 to the transaction value (assuming 5x EBITDA multiple). The reason for this is that the add-back increases Adjusted EBITDA by $50,000 and, thus, the valuation by: 5 x $50,000 = $250,000. In practice, there may be some back-and-forth on both the add-back amounts and the multiple, but otherwise it’s a straight forward calculation. An experienced advisor can help navigate this process.
We also counsel clients to be forthcoming and realistic about negative adjustments to EBITDA. These negative adjustments would be items that reduce EBITDA. Confusing? An example of this might be the need to hire a new CFO or other executive, which would be a new expense item post-transaction. Since negative adjustments will lower company valuation, many sellers are reluctant to present them to a buyer. However, if such items are obvious and easily determined, we believe they can enhance seller credibility with a buyer and make for a smoother negotiation. Keep in mind that a buyer is likely to propose various negative adjustments as they work through due diligence anyway. Thinking about any such items upfront can help facilitate deal negotiations as it may help prevent unexpected surprises.
Add-backs are utilized so that buyers can determine the underlying earnings capacity of a business (post-deal). To summarize, these items generally include various discretionary, non-recurring, and owner-related expenses. Below, we discuss some of the more common EBITDA adjustments:
- Owner salary and compensation – An owner can directly control what his salary is. If this salary amount is deemed to be above market levels, an add-back for any excess salary would be appropriate (along with payroll taxes). We may also need to adjust for spouses or family members that collect salary but are not active in the business. This category might also include owner benefits that are deemed to be above market.
- Other owner-related expenses – If the owner has personal or business expenses that are deemed to be too high or that would go away after a deal, they would be added back. Examples are personal vehicles, insurance, travel, entertainment, and club memberships. These items might be on the income statement purely as a tax mitigation strategy and are not essential to operate the business.
- Rent expenses – The seller may own the buildings and real estate in a separate legal entity. If this results in the company paying above- or below-market rent, the income statement should be adjusted accordingly to reflect a true market rent level. Even if the buildings are not owned by seller, if a buyer determines that a lease reflects under-market rent levels (and it is not assumable), they would make a similar adjustment to EBITDA.
- Other real estate considerations – Adjustments would also be made if the real estate is owned by the business, but it is not critical to operations. In this case, any real estate expenses (insurance, maintenance, etc.) would be removed from EBITDA and the real estate would be valued separately from the business. When doing this, it is important to remember to also adjust the business income statement (negatively) to reflect a market rent expense.
- Gaps in the management team – Is the management team well-rounded and deep, or is it largely driven by the owner-operator? Should a buyer need to hire new executives to fill out the team, there would likely be a negative adjustment to EBITDA for salary, benefits, and other items related to such hires. A common example is when a bookkeeper is the only financial executive, where a CFO or controller would be necessary post-transaction. An honest assessment of any management gaps helps build early credibility with buyers.
- Legal / Litigation items – Should the business be undergoing any one-time or highly unusual lawsuits, it would be appropriate to include these items as add-backs. Importantly, this would not include typical ongoing legal expenses that are common to a business.
- Other miscellaneous items – This could include any number of extraordinary items such as insurance needs or looming premium changes (i.e., positive or negative), upcoming minimum wage hikes (negative), fire or natural disasters that caused one-time expenses for repair (positive), a company relocation (positive), non-GAAP or unusual accounting practices (positive or negative), and deferred capital expenditures / maintenance on equipment (negative).
To learn more about EBITDA adjustments, read our related blog EBITDA Adjustments + 5 Expense Categories You Should Review for additional insight.
The above discussion only scratches the surface on what can go into Adjusted EBITDA. However, we hope it provides sellers a good understanding of what the process entails. We reiterate how critically important it is to get this calculation correct and not miss items that could impact valuation, either positively or negatively. This is why we always address the Adjusted EBITDA and valuation topics early in our discussions with potential clients, certainly pre-engagement.
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