Adjustments to EBITDA for Valuation Purposes
In our last blog we discussed what EBITDA is and why it is an important starting point for determining a business value. EBITDA has increasingly become the key metric to show the "intrinsic operational performance" of the business, but there are further adjustments that can be made when presenting financial data to prospective purchasers of your company.
This “Adjusted EBITDA” does not meet Generally Accepted Accounting Principles (GAAP) but nonetheless it is, in most cases, a reliable indicator of the operational performance of a business. These adjustments certainly can be challenged by a prospective buyer but they are part of the negotiation process during an acquisition. As I noted in our last blog it is not “free cash flow” as it does not account for non-operational cash inflows or outflows.
When I prepare a presentation for a prospective buyer, I like to segregate the adjustments in three broad categories.
1. Non-Recurring Expenses
Four to five years of operating statements should be presented to give an idea of business performance over time and as such each year will most likely have expenses that occur only once and are not repeated in the normal course of business. Some examples are:
Extraordinary legal fees
Expenses associated with developing/opening a new market
Special projects (a new website, Quality Assurance initiative)
Non-operating assets expenses-such as a lake house used for marketing or employee use that would not be of interest to a buyer
Aggressively categorizing capital expenses as repairs in order to minimize taxes.
2. Owner Discretionary Expenses
These are expenses that the business pays that are the owner’s preference and a new owner may not wish to continue. They are generally adjusted on a percentage basis:
Owners salaries-in some cases business owners are paid more than a non-owner executive would be. (This often cannot be eliminated as business continuity is important)
Personal travel that is part of a business trip
Non arm’s length transactions such as bargain sales to other businesses that may be owned by the shareholder
One time exceptional employee bonuses
3. Synergistic Expense Elimination
Assuming that the purchaser is another operating company, certain redundant expenses can be reduced or eliminated:
Overlapping executive personnel
Key-Man life insurance for a buy/sell agreement
This is by no means an exhaustive list of adjustments and it is written from the seller’s point of view where maximizing EBITDA is the goal. Adjustments will vary by industry and each business has its own unique characteristics.
As we noted, these adjustments can be challenged, so when they are presented they should be defensible, with the idea that they are legitimate business expenses but can be eliminated as they are not essential to continuing business operations.
In our next post we will discuss some terms used in business valuations.