Using Adjusted EBITDA to Add Back Value

The sale of a business is challenging on many levels. Arguably, the most difficult aspect of every transaction for buyers and sellers alike is establishing the value of the business that is being sold. Like beauty, value is truly in the eye of the beholder. For an owner who started a business and wants to sell it, determining its value is an emotional process. The seller’s goal is inevitably to maximize the amount of cash the buyer will pay for the business.

A buyer views an acquisition differently; he or she wants to price the transaction favorably so his or her shareholders will maximize their return from the investment. Herein lies the challenge of pricing a business.

There are several approaches for valuing a closely-held business, but the income-power model is the most-preferred method for determining the fair market value of a service business like a collection agency. The underlying theory is that a company’s “value” is denoted by the current income stream that owners accrue. The income stream is typically identified as EBITDA (earnings before interest, taxes, depreciation, and amortization), or the net cash flow of the business. A buyer will then apply a multiple to the selling business’ adjusted EBITDA.

EBITDA is a straightforward calculation. Adjusting or normalizing EBITDA to reflect the selling business’ true earnings is a challenge and needs to be addressed carefully to account for any excess or non-recurring expenses that will not exist after a sale. Typical adjustment areas include:

1. Susan, a long-term company employee who receives a $50,000 salary plus benefits, will not be employed post sale. Her responsibilities will be absorbed by other personnel within the company at no additional cost to the buyer.
2. One-time or unusual expenses, such as the cost of shutting down or opening up a call center facility, should be added back. However, trying to add back system upgrades is difficult because the buyer will view these expenses as recurring.
3. The cost of a Washington Redskins ticket or country club membership and monthly dues is a personal benefit to you, not the business.
4. Is your partner active in the business? If not, add back his or her salary and benefits.
5. Will you remain active in the business post sale? If not, you may be able to add back some portion of your compensation, but understand that a buyer will scrutinize this adjustment by evaluating your role and responsibilities.
6. If you own the building that your business occupies, you may be able to add back a rent adjustment. In some instances, an owner underpays rent to themselves as a benefit for owning the building. Expect a negative adjustment to earnings to bring rent up to fair market value.
7. A buyer may have to incur additional expenses running your business. For example, your business may not have a CFO. A buyer may see the need to hire one, thereby applying a negative adjustment to account for this additional cost.

Expect that a buyer will want to evaluate EBITDA trends over a few years, as well as your current year’s performance and projected EBITDA performance. Be prepared to produce these calculations early on in discussions with a prospective buyer because he or she will always ask for them. If it takes a while to produce this information, a buyer may get concerned about your financial controls.

Knowing the value of your business is crucial when selling. Contact our sister company, Topline Valuation Group, at questions@toplinevaluationgroup.com to learn more.