Monthly Archives: December 2017
Now that you can calculate EBITDA correctly it is time to drill down into the difference between Adjusted EBITDA and EBITDA. Before we review this important distinction, I think it is important to explain the reason for using another benchmark for valuation.
If you classify businesses as small, medium or large, breaking them up into categories based on sales, it would be safe to categorize lower-midmarket businesses in the following ways:
- Small sized businesses have less than less than $1 Million in Annual Revenue or Sales.
- Medium sized Businesses have between $1 Million to $20 Million in Annual Revenue or Sales.
- Large sized businesses have >$20 Million in Annual Revenue or Sales.
These categories of businesses are each represented by different types of advisors. Business Brokers do a great job selling the small businesses. Investment Bankers do a great job selling large sized businesses. Medium sized businesses are often represented by Brokers or Investment Bankers. The problem lies in the fact that there is a big difference between selling a mom-and-pop sandwich shop and a $15 Million Manufacturing business. Brokers who aren’t experienced in Mergers & Acquisitions have a hard time selling medium sized businesses due to these differences. There is also a big difference between selling a $40 Million-dollar Internet business and a $3 Million distribution business. For the same reasons, Investment Bankers have a hard time selling medium sized businesses. It doesn’t quite fit into their model. For these reasons, I believe, we have differing opinions about what EBITDA is and the need for ADJUSTED EBITDA to be calculated.
For example, let’s use a simplified example to explain the problem. A small business usually has an owner-operator who runs the business. For these businesses SDE (Seller’s Discretionary Earnings) is the most important number to use to assess as an income multiplier of value. The reason SDE is used is the buyer of the business is most likely to run the business himself and replace the owner and his function.
With a medium sized business, the new owner may or may not replace the current owner. The current owner may have a manager in place to run the day-to-day operation and not need to be replaced. If this is the case, then EBITDA or ADJUSTED EBITDA would be more a more relevant income multiplier of value.
Larger sized businesses rarely have an owner operator who will be replaced so EBITDA is the best revenue multiplier to use for valuing the company. It is the medium sized businesses that have the most problem with what multiplier to use for four reasons:
- SDE and EBITDA both may need to be applied as an income multiplier for a fair valuation.
- EBITDA doesn’t always paint a true picture of cash flow if the current owner of a business needs to be replaced after the business is sold.
- Discretionary expenses (perks) are not accounted for in the EBITDA Calculation. In many medium sized businesses there are discretionary expenses that should be added back to income since they will no longer be an expense for the new owner of the business.
- One-time losses and Revenue are not accounted for in a simple EBITDA calculation.
- Lease expense over or under market isn’t accounted properly when the current owner of the business owns the real estate that the business is leasing.
For this reason, the new market practice is to use ADJUSTED EBITDA. Adjusted EBITDA is calculated as follows.
|Pretax Income (loss)||225,000||425,000||625,000|
|Wages of Owner||175,000||175,000||175,000|
|Payroll Taxes – Owner||10,718||10,718||10,718|
|Health Ins – owner||10,000||10,000||10,000|
|Loss on Sale of Assets||10,000||–||–|
|One-time Bad Debt||5,000||–||–|
|Lease over charged||15,000||15,000||15,000|
|Gain on sale of Assets||–||6,000||–|
|Seller’s Discretionary Earnings||$511,718||$701,718||$896,218|
|Less: Cost to replace owner||(125,000)||(125,000)||(125,000)|
This is the correct calculation of Adjusted EBITDA as shown in a Valuation Report by My Biz Value.
The bottom line is for the 5 reasons listed above, ADJUSTED EBITDA is a more important and relevant metric to use as an income multiplier when calculating true cash flow and the value of a medium sized business.
Now that we have a good baseline Earnings number we need to look at Interest, Taxes, Depreciation, and Amortization.
Interest Expense. The interest you can add back is all interest from debts and credit cards and consumer debts. It also can include finance charges. What interest does not include is bank fees, charges, or merchant fees. The interest you can add back is all interest that the new business owner would not have if he were paying cash for the business and had zero debt.
Taxes Expense. The taxes you can add back are income the taxes for the company. This add-back only applies to C-corps that you use a baseline number of Earnings After Taxes and not before taxes. If you use Earnings before taxes as a baseline number, then you don’t have to add back taxes for a C-corp. since the tax expense hasn’t been added to the Income Statement.
It doesn’t apply to S-corps or LLC’s or Partnerships. This includes all state and federal income taxes. It does not include payroll taxes, sales taxes, or local taxes. This is the tax your business pays. When you have an S-corp or Partnership the taxes flow through to the owners as individuals.
Depreciation and Amortization Expense. These can be found at the following locations on the tax returns and financials.
- Compiled, Reviewed or Audited Financials – look on the Statement of Cash Flow for the Depreciation and Amortization Expense if it is not shown on the Income Statement, Statement of Revenue and Expenses or Statement of Operations.
- Schedule C – sole proprietor – Line 13 and 27a for Amortization Expense
- Form 1120 – Line 20 or the Statement for Line 26 for Amortization Expense
- Form 1120S – Line 14 or the Statement for Line 20 for Amortization Expense
- Form 1065 – Line 16c or the Statement for Line 20 for Amortization
- Internally Generated P&L – Depreciation and Amortization are usually shown as line items expenses.
One item to note is Section 179 depreciation is not an item you add back.
These are the expenses you add back for a simple calculation of EBITDA. This is place where you start to calculate “Adjusted EBITDA”. In Part 3 of 3 this post I will cover Adjusted EBITDA, how it is defined, and how it is calculated and used.
There is a lot of discussion in the M&A world about EBITDA and a wide variety of opinions about what is included and what is not included. Many advisors, sellers, and buyers are using an “adjusted” EBITDA figure for sales transactions. How do EBITDA and “adjusted” EBITDA differ? This is part 1 of a 3-part series about the important metric we call EBITDA.
Calculating EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) may seem like a simple thing to do, but there are many factors that come into play that aren’t part of an over-simplified calculation. These include: owner wages, replacing the owner, perks, excess wages, discretionary expenses, partners and their roles, etc.
Let’s begin with the baseline number: Earnings. Earnings has many titles including: Sales, Gross Profit, Net Income, Taxable Income, etc. It is easy to get confused by these titles and not understand the true meaning of the word as it pertains to EBITDA. In a recent transaction I had a business owner who “swore” his business was worth 1.5x Earnings. He had understood Earnings to mean Gross Sales, not EBITDA. He was using the right multiple with the wrong number for Earnings. Here is a list of where you can find “Earnings’ to use as a baseline for calculating EBITDA:
- Form 1120 S (S-corp). Ordinary Business Income – Line 21
- Form 1065 (LLC/Partnership). Ordinary Business Income – Line 22
- Form 1120 (C-corp). Taxable Income – Line 30
- Net Income from an internally generated P&L
- Schedule C – Net Profit or Loss – Line 31
- Income Before Taxes on an Income Statement. Interest.
Once you have a good starting number you can proceed to Step 2 of calculating EBITDA. This will be covered in Part 2 of this series.
Working Capital is defined simply as Current Assets Less Current Liabilities. Some advisors will include a certain amount of average inventory in Working Capital as well. Some advisors do not include Inventory in the Working Capital. Because of this it is important to define Working Capital as it pertains to each individual deal.
Inventory can be included in the Asking price and can be excluded. A good rule of thumb is for deals over $1 million, a normal amount of inventory is included in the Asking price and not included for smaller deals. Excess inventory (inventory that is escalated due to the seasonality of the business) is usually not included, even for transactions over $1 million. For this reason, it is important to pin down a good average inventory number in the LOI phase of the deal.
Working Capital Target. This is the amount of Working Capital that is required to be sold with the business. Working Capital is a moving target, so it is helpful to set a benchmark amount for closing and adjust the Selling Price up or down accordingly. It is very important to set expectations for this amount at the LOI phase of a deal because expectations about this can differ and cause a deal to unwind unnecessarily.
Working Capital is generally not considered in deals smaller than $1 million in deal size, but it is an important part of deals over $1 million. Working Capital is an important element of a business sales transaction and should be a consideration of every deal. Even small deals will require the Buyer to consider how much Working Capital she or he will need after closing.
When determining the value of a business there are many terms which can be confusing. The term most often used if Fair Market Value and is defined as:
The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
1. The Buyer and Seller are typically willing and knowledgeable.
2. Both parties are well informed or well advised, and each acting in what they consider their own best interests.
3. A reasonable time is allowed for exposure in the open market.
4. Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto.
5. The price represents the normal consideration without special or creative financing or sales concessions to outside parties.