Let’s talk about deal influencers. Everything from the structure of your deal to Earnout Provisions can drive your company’s sale price up or down and influence the value of your deal – its ultimate deal value. In this article, we will discuss one of these deal value influencers, Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA).
EBITDA is a widely-used measurement of a company’s ability to generate profit from operations. It is a measurement used internally by both privately-held and publicly-traded companies as a benchmark to assess profitability. Bankers make lending decisions based on it and investment bankers generally use it as a starting point for the valuation of most acquisition transactions. In fact, deals are often valued based on a multiple of the EBITDA calculation. And yet, interestingly enough, EBITDA is not a concept defined in generally accepted accounting principles in the United States (GAAP), which means that EBITDA is not reported on the face on an audited income statement. With the exclusion of principal and interest payments on debt, income tax payments, and capital expenditures, EBITDA tells only half the story as far as operating cash flows of a company are concerned. Furthermore, because the metric is not found in GAAP, the calculation can be highly subjective and can vary significantly among companies. Even with its limitations, the fact remains that EBITDA continues to be a major element of many transaction structures, an element that significantly impacts deal value.
Understanding the Role of EBITDA in Your Deal
Given the subjective nature of EBITDA, the calculation a company uses to arrive at EBITDA for purposes of a transaction can differ significantly from company to company. In order to present the strongest EBITDA possible, a seller is motivated to add back all nonrecurring expenses, as normalization adjustments, that a prospective buyer will not incur post-transaction. A buyer may have a different motivation concerning the calculation of EBITDA depending on the dynamics of the deal. If the buyer is financing the acquisition with bank debt, then a minimum threshold for EBITDA in order to secure financing may exist and therefore the seller would share the buyer’s motivation to present the strongest EBITDA.
In our role of providing financial due diligence services on both the buy-side and the sell-side, a significant amount of our effort is focused on gaining comfort around EBITDA. Because of the subjectivity of the normalization adjustments to bring EBITDA to a post-transaction expectation, much time is spent during the diligence process identifying and assessing normalization adjustments.
If you are considering selling your business, it’s a good idea to ask yourself the following questions in order to ensure your EBITDA is properly normalized:
- Are there common, one-time items included in your results from operations that are not expected to be realized going forward? Examples would include: one-time vendor rebate income or legal expenses relating to the impending sale of the company.
- Are there excess compensation charges that are not expected to continue post-sale? For example, perhaps the owner of the company is being compensated at a higher rate than market.
- Are there costs of benefits that are not expected to continue post-transaction, such as retirement plans or stock-based incentive plans?
- Can documentation and a reasonable rational be provided to support the normalization adjustments?
In contrast, when you are the buyer in a transaction and the goal is to create a solid expectation of post-transaction EBITDA, you’ll want to ask the following questions:
- What are the potential revenue streams, if any, that are not expected to continue post-acquisition?
- Are there additional costs will that be incurred to build out the management team?
- Will there be efficiencies gained and, in turn, costs which will be eliminated going forward?
- Are there additional benefit costs that will result from the integration of the seller’s employees that may erode post-transaction EBITDA?
Regardless of which side of a transaction you sit on, having a firm understanding of the questions to ask to take control of your deal as it relates to EBITDA will allow you to ultimately achieve greater value in the long-run.
What Else Can Influence Your Deal Value?
EBITDA is just one of the many financial items that can have an impact on the valuation of your company. Stay tuned for future articles where we will explore additional concepts to help you get the most out of your deal.
If you would like to further explore the ideas we have presented, please do not hesitate to contact us.