While there are many factors that influence the valuation of a business (including size, profit margins, historical growth, growth potential, competitive positioning, and customer concentration), one of the most closely scrutinized metrics is earnings before interest, taxes, depreciation, and amortization, or EBITDA.
The calculation of EBITDA is generally quite simple from an income statement. However, adjustments may need to be applied to get to the standalone, go-forward level of EBITDA that buyers should expect to see post-closing. These are typically expenses that won’t continue following a transaction, and can materially impact the financial presentation of the business and the resulting valuation. An experienced advisor can help to determine which adjustments are appropriate.
Most adjustments fall into one of the following categories:
- Owner expenses – if, for example, the company is paying for additional benefits for the owner beyond what other employees receive, we can remove those excess expenses and adjust to a level of compensation and benefits that would be received in an arms-length arrangement with an individual non-owner employee fulfilling the same role.
- One-time expenses – any one-time projects or expenditures that a buyer would not expect to pay for going forward. This may include professional fees (such as a consulting project or legal fees outside the ordinary course of business), or anything else that is non-recurring in nature.
- Exclusion of non-operating income or expense – any income or expense not associated with the core business being sold should be excluded from the calculation of EBITDA. For example, investment income or forgiveness of a PPP loan should not be considered as part of the ongoing profitability.
- Normalization of expenses – a normalizing adjustment may be necessary to adjust any transactions with affiliated parties to a market level. For example, if the company rents its facility from an affiliated landlord for a rate well below the market rent rate, an adjustment to EBITDA may be needed to bring rent up to a market level.
- Adjustment for recent investments or efficiency improvements – if the company has just recently made process improvements that will drive significant, quantifiable cost reductions, we may be able to consider a retroactive adjustment to the historical period to show what savings could have been achieved with the new systems. This only works if there a clear, supportable way to estimate the cost savings.
Some things that generally would not be added back include:
- Owner salary if the owner is actively involved in running the business. If owner salary is above market levels, we may normalize it by reducing it to a market level.
- Compensation that has historically been paid to employees on a regular basis and would likely be expected going forward (i.e. year-end bonuses).
- Regular, “maintenance” levels of investment in R&D, systems, and sales & marketing. If there’s a one-time, unusual level of expenditure to drive future growth, we may consider normalizing this to a more typical level.
It’s important to think through EBITDA adjustments carefully to be sure that all adjustments are documented, supportable, and rational. This is one of the many reasons that it’s helpful to have an experienced M&A advisor on your team.
Kate Soto is a partner with Mirus Capital Advisors. She works with owners of middle market businesses and can be reached at email@example.com.