EBITDA, a common M&A term, is defined as Earnings Before Interest, Taxes, Depreciation and Amortization. To learn more about EBITDA, check out this post: Defining EBITDA.
Now that you understand the basics of EBITDA, let’s dive into “Adjusted EBITDA” and what it means in the sale of your business. Adjusted EBITDA differs from regular EBITDA as it takes into consideration historical, one-time and/or discretionary expenses that will not occur after a transaction. To calculate your company’s Adjusted EBITDA, simply add these adjustment items to your base EBITDA. These adjustments “normalize” your numbers on a go-forward basis and, if buyer and seller agree on their validity, buyers will use Adjusted EBITDA to value your company, often to your benefit. If you’re considering selling in the near term, it’s important to understand how to calculate Adjusted EBITDA for your business as this is common metric for valuing a company.
Examples of EBITDA adjustments and how they are handled
Example 1: Off-Market Owner Salary - You, as the owner and CEO of your business, receive a salary that is significantly higher (or lower) than “market” salary for your position. If market salary for a CEO of your size company, in your industry, is $150,000 and you’ve been receiving $300,000, you can add back that additional $150,000 to “normalize” the ongoing expense of your replacement. On the flip side, if you’ve been paying yourself below market, say $80,000 annually, there will be a negative adjustment to EBITDA ($70,000) to offset the go-forward cost for your replacement.
Example 2: Lack of Health Insurance - Your company does not currently offer health insurance to employees. The buyer is a strategic in your space already providing health insurance to their own employees, thus, they will offer health insurance to your employees moving forward at the cost of $100k annually. In this situation, there is a negative $100k adjustment to EBITDA to account for this new go-forward expense.
Example 3: Donations – Each year, you find several charities that are important to you and your company contributes $75,000 to these non-profits. Going forward, the buyer will not be expected to continue these contributions, thus you get the benefit of a $75,000 positive adjustment to EBITDA.
Example 4: Rent Adjustment – You own the building your company operates out of in a separate entity. As such, you get to determine and allocate whatever rent amount you wish. If you charge your company a higher than market rate, let’s say $200,000 annually, when market comps show it should be closer to $125,000 annually, as long as you offer a go-forward rent rate of $125,000, you’ll get a $75,000 adjustment to rent. Alternately, if you’re only charging yourself $100,000 currently, but you expect a go-forward rent rate of $125,000, there is a negative adjustment to EBITDA because the company will have an additional $25,000 of expense post-closing.
Other examples of common EBITDA adjustments: lawsuits, certain one-time R&D expenses, extraordinary owners’ salaries/bonuses, start-up costs, entertainment, special donations, golf course memberships/season tickets, personal vehicle leases, computers or phones for family members, etc.
(Note that EBITDA and EBITDA adjustments are only related to P&L items, not balance sheet items, so you wouldn’t add back shareholder distributions or the cost of a new personal vehicle. For a vehicle, you’d get the benefit of the related depreciation that hits the P&L each year.)
Most of these expenses are added back because they are one-time, extraordinary events (i.e. litigation or sale of a non-core asset) or personal decisions made by the seller (i.e. charitable donations, extraordinary entertainment expenses, etc.). When the seller transitions out and new ownership takes the reins, these discretionary expenses will change or cease to exist. Prior to going under contract, buyers must assess the REAL ongoing profitability of the business they are acquiring, and value the business based on Adjusted EBITDA. If your Adjusted EBITDA is higher than your EBITDA, valuation will likely be higher for your business.
If you have questions about how buyers would view EBITDA adjustments for your company and how to maximize your transaction, give us a call at 704-295-0102.