Buyers look at many metrics and indicators when considering an acquisition, but one of the most common is EBITDA. As a business owner or CEO considering a sale, it is therefore essential to understand what EBITDA is and how it can impact how your business is perceived.
What is EBITDA?
EBITDA stands for earnings before interest, tax, depreciation and amortization. Although this sounds complicated, it is simply operating profit plus depreciation and amortization.
EBITDA is a widely used measure of profitability because it is unaffected by the amount of debt in the company or by taxation. This makes it easier to compare the profitability of companies in different circumstances or sectors. It can also be used as a proxy for cash flow because it does not include depreciation and amortisation which are non-cash items.
EBITDA in M&A valuations
Buyers will use a number of techniques to assess the Enterprise Value of a business, but will commonly do this by applying a multiple to EBITDA (also known as the EV/EBITDA ratio).
For example: £6.3m EBITDA x 10 EV/EBITDA multiple = £63 million Enterprise Value
Remember, Enterprise Value is a combination of all value attributable to the business, including net debt. Therefore, it is important to understand the difference between Enterprise Value versus the residual Equity Value which will be paid to the shareholders after net debt.
Despite being a commonly employed measure of operating profitability, EBITDA is not actually defined in any accounting standard. Therefore, if you are the owner of a business and are considering selling it, you might well want to consider how best to present your company’s EBITDA metrics, to improve the chances of a sale at the best possible valuation. As part of this you could consult an expert advisor who can offer advice on what buyers are looking for, how they are influenced, and how you can present your company to attract the most attention.
Adjustments to EBITDA
Adjustments to EBITDA are made to create a normalised level that strip out any non-recurring or exceptional items that may distort profitability. For example, with founder-owned businesses in particular, there are often significant cost items in the accounts which are not related to the profitability of the underlying business. Alternatively, a buyer can make adjustments if they believe the EBITDA presented does not accurately reflect the costs required to support the growth plan.
It is also important to note that EBITDA is a profitability measure and so does not include any capex. Therefore, if you are capitalising a significant amount of software development under R&D rules for example, a buyer may deduct this value from your EBITDA to achieve a better approximation to operating cash flow.
EBITDA adjustments are therefore often highly subjective and a key aspect of the negotiations as they can have a resulting impact on price at the relevant EBITDA multiple.
Some common examples include:
|Adjustments to EBITDA||Explanation|
|Add back: Exiting shareholder costs or personal expenses
|If there are non-operating costs relating to exiting shareholders which will not form part of the business post-transaction, they are irrelevant to the underlying profitability
|Add back: Transaction or other advisory fees||This could include one-off fees relating to advisory on the sale of the business which is not related to normal trading
|Deduct: Above market rent or fees paid to related entities||Sometimes owners may choose to pay higher rates of rent or management fees to a related entity, but these should be stripped out of the target business if they will not continue post-sale
|Deduct: adjustment for market rate salaries||Owners often choose to remunerate themselves with a low salary but instead take dividends which do not impact EBITDA. If a buyer needs to bring in new management, they might make a correction for market rate salaries
|Deduct: capitalised software development costs||Although capex in nature, buyers may argue this is a cash cost required to support the business
|Deduct: exceptional or non-operating income||If there are inflows to the business such as litigation settlements, a buyer would likely strip these out as non-recurring
Importance of the EBITDA multiple
Let’s consider a scenario where a buyer is willing to pay 10x EBITDA of £6.3m = £63m EV. If you can negotiate an adjustment to EBITDA of +£300k, that results in a total price increase of £3m, which is significant. But what if you could also increase the multiple to 11x EBITDA? That would result in a price of 11x £6.6m = £72.6m EV, a substantial improvement on the original price.
So what multiple will a buyer apply to EBITDA? This depends on a number of factors such as your historic and forecast growth rates, comparable market transactions, and the buyer’s own valuation EBITDA multiple. To get the best EBITDA multiple possible you must justify your rationale for a higher price to the buyer through a strategic and competitive communication process.
What do I need to prepare?
Buyers usually look for at least two years of historic EBITDA in addition to the current year’s figures, so that they can analyse and understand historic trends. It can take time to produce these numbers for the first time, so it is often a good idea to discuss this with an advisor 12-18 months before thinking about a sale.
This will give your accounting team time to identify financial issues, fix problems, and present your EBITDA trends in the best light. EBITDA can be an extremely useful measure of profitability, but it is important to understand it within the context of your business needs so that you can apply it effectively. An advisor can guide you through all the necessary steps in calculating EBITDA to ensure you achieve the best possible deal.
What if I am investing all profits in future growth?
It is not uncommon, particularly in technology, for owners of a business to choose to reinvest heavily in top line growth. This means that a business could be loss-making and therefore the EBITDA multiple is not a relevant valuation method. However, buyers will want to understand what your path to profitability looks like and your cash burn and so you will need to have a clear long-term plan for profitability and future returns.
How we can help
FirstCapital are experts in what buyers want from potential M&A partners and how business owners can meet these expectations. We have worked with many clients and their accountants in the preparation of financial statements in order to deliver a successful sale.
To get advice on how to prepare your business for an M&A deal, get in touch with a FirstCapital advisor today.