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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.
When a business is sold, Working Capital (Cash, Accounts Receivable Inventory, and Accounts Payable) are usually included in the sale for businesses with a value over $1 million and not included for businesses worth less than $1 Million. When it is included, a “normal” amount of Working Capital is included, but the term “normal” varies greatly and is part of the negotiation process. The Working Capital is a measure of cash a business needs to support day-to-day operations, but when evaluating a company for an acquisition, not only is total Working Capital important, the change in working capital before Close should be watched as well. A Working Capital Target should be negotiated at the time a LOI is signed.
Relying solely upon a multiple does not take into consideration additional working capital a buyer will need for the newly acquired business, post-close. Working Capital is an important consideration to make when a business is being bought or sold regardless of the EBITDA multiple used for value.
Real Estate Improvements – Tenant Improvements
A Purchaser of a business generally will assume a location, whether through a lease or a purchase of property. Tenant improvements are often missing from EBITDA multiples, yet he cost of the improvements are often an expense post-close as the acquiring party invests in paint, signage and other improvements to ensure the acquired location matches the Purchasers standards. When evaluating the cost of an acquisition, if tenant improvements are anticipated, they should be included as an expense when calculating EBITDA.
Future CAPEX or capital expenditure needs are not included in the EBITDA of a business. These are the funds a company uses to buy or upgrade the physical assets of the business. If you have a business that has very little fixed assets, it isn’t important, but if you have a business which is capital asset intensive (trucking or manufacturing) the depreciation is a cost that should not all be added back when the company considered is a capital-intensive business. In these cases, EBIT (Earnings Before Interest and Taxes) would be a better multiple to use for these types of businesses.
CAPEX represents depreciable assets, yet, these expenses are removed from EBITDA. The problem with this is CAPEX is a very real cost, and a critical consideration when evaluating a business. Because of this, it is important to include projected CAPEX expenditures post-close when evaluating the entire value of the business.
Multiples are a quick and easy way to evaluate and compare multiple deals across an industry. EBITDA provides a “tried and true” method to calculate true cash flow, but both can be misleading, and, when not fully understood, are prone to manipulation. When an advisor is evaluating the merits of an acquisition, it often pays to devote the extra resources to develop a financial model that takes CAPEX, Tenant Improvements, and Working Capital into consideration.
My Biz Value was founded by a CPA who spends time in the trenches, managing mergers and acquisitions of companies with high growth potential. Rick Krebs, dubbed an “expert sale-side advisor” by Forbes, developed the My Biz Value system because he’s passionate about helping entrepreneurs and business owners achieve successful transactions. He’s also obsessed with timeliness, accuracy and value.
MyBizValue is pleased to announce the availability of a revolutionary business valuation report. This important report is now available to business owners in the US. MyBizValue, the premier business valuation company, is now offering CPA-prepared business valuations from $499-$999. These valuation reports capitalize on the latest technological advances to prepare custom Business Valuation reports for privately-held businesses. This important tool was designed by our founder, Rick Krebs, CPA who has over 24 years experience valuing businesses.
The new Valuation Report is designed for business owners, sellers, and buyers of businesses who want to know the value of a business without paying thousands of dollars. When it is important to know the value of your business this report is just what you need. Knowledge is power and this report provides the information necessary to make a smart buying or selling decision. After years of being frustrated with the available business valuation software, the founder of MyBizValue developed his own unique software to prepare these reports. The Standard Report contains 30+ pages of information utilizing 5 valuation models. The Comprehensive Report provides additional empirical support when the numbers will be scrutinized by outside parties, the courts, or the IRS. Both offer the same number, just different support for each.
August 15, 2017
Congratulations to Jenny and Jared for the successful sale of Home Comfort Care. The Buyer is part of a local PE Group that purchases and grows small businesses.
Rick Krebs of Business Sales Group is pleased to announce the sale of another business. Rick Krebs was the sale-side advisor for this successful transaction. This sale is private and the team (Rick Krebs and Heather Krebs) at Business Sales Group is pleased to have been a part of this sale. We found a great buyer who is very pleased with his purchase and excited to move ahead with the explosive growth of this business. They increased sales dramatically within the last 30 days and that rapid expansion is expected to continue. Congratulations to the Buyer and Seller!
Business Sales Group is a M&A Advisory/Business Brokerage located in Utah that advises clients across the Rocky Mountain Region. Rick Krebs and Heather Krebs are the two principals. Visit www.Bsalesgroup.com for information or to obtain a business valuation, visit www.BusinessValuationsGroup.com
Business Sales Group is pleased to announce the successful sale of Twin Pines Motorsports. This dealership sells, services, and leases Arctic Cat ATVs, UTVs and snowmobiles. They also repair and service all types of motorsports machines.
Congratulations to Mitch and Barbara (Buyers) and Kurtis and Carla (Sellers). They were ranked by customers as the #1 Arctic Cat dealership for customer satisfaction in 3 Western States.
Our Small Business Division just sold another great business in Heber City, UT. We sold the Dickeys restaurant on main Street. The new husband and wife owner/operators are excited to move forward developing the walk-in and catering business. Dickeys is the largest barbecue chain in America with over 500 franchises. Congratulations to Kevin and Barbara and their family.