What does EBITDA mean?
Why is EBITDA used?
EBITDA is an approximation of the operating cash flows of a business. Net income is looked at as the profit of a company but not all of that is cash. EBITDA helps create an apples-to-apples comparison for investors looking to acquire companies. No two companies are alike in terms of capital structure, leverage, geography, corporate structure, and asset base. Using EBITDA is a way to attempt to measure a company’s overall financial performance and compare it to other companies. Depreciation and amortization are non-cash expenses and, since the objective is to approximate operating cash flows, are added back. Interest and taxes, on the other hand, are expenses paid in cash but are added back for different reasons.
Two similar companies could have the same profit, but one may have significantly more leverage, or debt, on the balance sheet. This would result in more interest expense. Transactions are assumed to be made on a debt-free basis, meaning any outstanding debt the business has at the time of the transaction would be paid off. Assuming there is no debt also assumes there is no interest expense, therefore it is added back to help compare companies on a more level playing field.Similar to how companies can have different capital structures, companies can also have different corporate structures. If a business is set up as an LLC, Partnership, or S-Corp, it will have taxes passed through to the owners. These “pass through entities” will be taxed differently than a C-Corp, whose taxes will be paid by the business itself. To account for these differences, taxes are added back. Corporate structures often change during a transaction. Sometimes “pass-through entities” will be changed to a C-Corp after the sale of the business and the owners will no longer be paying the taxes for the company. When valuing a business, buyers will want to have an idea of what EBITDA would be if they owned the company right now. Under this assumption, there are other expenses that can be added back to get EBITDA on a more comparable basis.
EBITDA Add-Backs
Business owners often run personal expenses through their company’s income statement. This would not continue if the business was purchased by an institutional investor. To account for this, add-backs are made to EBITDA to get to adjusted EBITDA. Adjusted EBITDA is often the primary metric used when calculating the valuation of a company as it considers what the business would look like under different ownership. Some items like personal and family cell phone plans, insurance, and vehicle costs are expensed to the company. These are typically added back to EBITDA due to the fact that the company would not pay for personal expenses under new ownership.
Additional add-backs commonly seen are excess compensation, professional fees, transaction fees, rent, and one-off expenses. If a business owner is paying themself an above-market salary, the amount above market rate can be added back to EBITDA. Buyers will assume that under new ownership, the new CEO or president, along with other key employees and executives, will receive a salary comparable to their position at similar companies. If key employees are paid below market salaries, this could decrease adjusted EBITDA as it is expected that the new owners will want to retain key employees and increase their salaries to market rate. Expenses incurred relating to the company’s sale, including professional fees paid to attorneys, accountants, and advisors, would be added back, seeing that another capital transaction would not be expected in the near future. Rent is another expense that could be added back if the company is paying above-market rates or the rent situation for the company is expected to change post-transaction. One-off expenses, or expenses that the company incurred that were out of the ordinary course of business, such as property loss due to damage or theft, remodeling expenses, and others, can also be added back to EBITDA as it can be assumed these would not continue to occur in the future.
All of these add-backs are calculated to create an adjusted EBITDA number that will allow investors to view companies as objectively as possible in terms of profitability. Adjusted EBITDA does not equal the value of the company, however, which brings up the question, how is it used for valuation purposes?
How is EBITDA used?
Once adjusted EBITDA has been calculated, buyers will typically apply a multiple to this number to arrive at a valuation. For example, if a company has adjusted EBITDA of $5M and a buyer offers 8x adjusted EBITDA, the company’s valuation would be $40M. The multiple applied can be dependent upon a variety of factors. Larger, higher-margin, and faster growing companies will often demand higher multiples than their less attractive peers. Certain industries can receive higher multiples than others depending on market conditions and demand for companies in the space. The type of buyer can also factor into what multiple is offered. Some firms will typically have a range of multiples that they will bid on all companies, whereas others may be able to realize synergies and be willing to offer a higher multiple.
The goal when helping a company through a sell-side process is to position the company as best as possible, find all appropriate add-backs to maximize EBITDA, and connect with the most buyers that will price the business correctly. Creating competitive tension between interested buyers can help improve the seller’s outcome. Crewe Capital has advised companies in a wide range of sizes and industries and has the network and knowledge to run an effective sale process to meet the needs and desires of our clients. If you are curious about the EBITDA of your company and what we think the value of the business could be, we would be happy to discuss what we are seeing in the market and how Crewe Capital can help you get the most for your business.
