So what is the deal with EBITDA, and why does everyone talk about it when determining the value of a company?
EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Sounds simple enough, but EBITDA isn’t always what it seems.
For a buyer to get a true measure of profits for a middle market company, they’re going to want to know what kinds of expenses were run through the company that were uniquely to benefit the owner and not necessarily a pure business expense.
That means that there are basically two ways to calculate EBITDA, and we’ll get to that in a moment, but first you should know that the EBITDA your banker wants to see and the EBITDA you want to show a potential buyer of your company are two distinctly different calculations.
In general, buyers pay a multiple of EBITDA. The concept is similar to the price earnings (P/E) ratio used to value companies on the stock market.
The multiples vary by industry and by individual company performance. Multiples of EBITDA are affected by both industry and macroeconomic business cycles.
That’s why it is critical that you take great care in showing the correct calculations for EBITDA to a prospective buyer. If you show the banker’s version of EBITDA, it could literally cost you millions of dollars.
When it comes time to sell your company, you will likely run across terminology like:
- Restated EBITDA
- Recast EBITDA
- Sellers’ Discretionary Cash Flow
- Owners’ Benefit
- Restated Cash Flow
- Recast Earnings
- Net Income after Addbacks
- Restated Earnings
All of these are really designed to tell a potential buyer what’s in it for them. In other words, if they become the owner, how much of your income statement will flow to their benefit.
So, how do you figure out the EBITDA that you should show a potential buyer for your company in any given year?
Start with Net Income
- Add Back Interest
- Add Back Taxes
- Add Back Depreciation --
- but subtract normal annual capex.
- Add Back Amortization
That’s the standard EBITDA calculation. However, before you send that off to a potential buyer, you’re going to want to add back a few expenses that were either extraordinary items or expensed compensation for you, the owner.
For instance, you’ll want to:
- Add Back Excess Owners’ compensation and benefits. For example, let’s say you and two family members work for the company you own, and you pay yourselves $500,000 in combined salary and benefits. If you were hiring for these positions in the free-market, you might pay $300,000 for the same 3 workers. In this case, $200,000 is excess owners’ compensation and may be added back. You might also run your car through the company. Perhaps you have a hunting lease, or a vacation home that you use to entertain clients. All of those are potential add backs.
- Add Back certain One Time Expenses, such as an unusual legal expense or loss on the sale or disposal of an asset.
- Add Back Excess Expenses, such as items expensed in one year that should have been expensed over several years. You’ll add back the part that should have been deferred.
That is why this type of EBITDA is typically referred to as Recast EBITDA or Restated EBITDA. You’re restating the calculation that shows up on a typical financial statement to more accurately reflect the excess expenses that inured to the owner’s benefit.
It is best to let a professional review and prepare a proper EBITDA analysis for purposes of selling your company. Buyers like to see at least 3 years of EBITDA, so there’s lots of room for error, here. If you slip up, the multiplier effect can literally cost you millions.
When we create a valuation for you, we gather at least 3 years of detailed financial statements, so that we can determine what add-backs should be factored into recasting your EBITDA. We’ll work with you to ensure that all of these items are legitimate, and that they make sense to you and to a potential buyer.
We’re a boutique business intermediary, so we are very selective about the kinds of businesses we represent. That’s also why we have a track record of success, selling over 90% of the businesses we choose to work with.
We start that process by offering a free valuation to qualified companies. If you’d like to talk with us about getting a free business valuation, you can learn more about it here.