Calculating your Company’s True Profitability: What Adjustments to EBITDA are Appropriate?

While hardly the only option, it has become fairly routine for middle market transactions to use EBITDA as the measure of value.  EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization.  So, it is effectively a company’s net profit plus any expenses incurred for interest, taxes, depreciation and amortization.

Despite sounding like a relatively straightforward calculation, it is important to carefully analyze this number along with the company’s financial statements so that adjustments can be made to EBITDA to more appropriately present the company to potential acquirers. These adjustments go by various names, most frequently being referred to as add-backs.

Why are adjustments necessary?  In the middle market space, it is very common for companies to incur or account for certain expenses that wouldn’t be treated in the same way by a buyer. Consequently, it is important to normalize these sorts of expenses to more typical accounting practices.

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Generally, these add-backs fall into two main categories:  compensation related adjustments, and one-time expenses.

First, because often, owners of middle market companies also work in the business, it is important to distinguish between the two streams of money that the ownership group derives from the company: (i) salary due to the owners’ work in the business, and (ii) distributions due to the owners’ stake in the company.  There are a couple of permutations of this analysis depending on the salaries and benefits taken by the ownership group, but the important factor is to “right-size” the compensation package to fair market value.  This could include reducing excess salary paid to the owners, increasing substandard salary, or accounting for a variety of additional compensation items or perks.

Second, adjustments need to be made for one-time expenses.  These tend to include both fortuitous and catastrophic events that aren’t expected to reoccur regularly (e.g., an extraordinary sale or a one off piece of litigation).  They can also include one time investments that the company made to grow its existing business or a new line of business (e.g., a move to a larger office, R&D expense, new sales hires that need a period of time to come up to speed).  While these expenses may be appropriately expensed on the company’s tax return, from an economic perspective, they need to be amortized or otherwise trued up to present a more appropriate picture of the company to potential buyers.

Evaluating the company’s EBITDA and appropriate adjustments is a crucial part of planning for a transaction.  Because businesses tend to be sold at a multiple of EBITDA, each dollar of appropriate adjustments could be worth many dollars in purchase price.

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