There is a type of business valuation software and service available that allows a business owner to input their own financial information. Although this may seem like a good idea, it is a very bad practice. Valuations, like tax returns are complicated and require a seasoned professional to analyze and input the data to get an accurate number for value. One of the main reasons that a business owner would not want to do the valuation themselves is there are key expenses that can be added back into the EBITDA and Cash Flow calculation. If these expenses are missed, the valuation number is inaccurate.
Key add backs and charges tend to be buried in the tax returns or financials and are easily missed. These include:
- Amortization Expense, which is usually shown on the Schedules and buried in the tax return.
- Section 179 Depreciation Expense, which is usually shown on Schedule K-1 of the Tax Return and erroneously added back with the rest of the depreciation.
- Partner Wages and cost to replace the owners for a situation where there is multiple partners who own a business.
- Cost of a working spouse who is not paid.
- Adjusting the lease to the market rate.
- Correct calculation of SDE, EBITDA.
- Repair and Maintenance Expenses that need to be capitalized.
- An S-corp tax return will show more Taxable Income (Net Income) than the P&L due to the expenses and pass through items on the Schedule K-1’s. If the business owner doesn’t understand income and pass-through entity taxation, he will undervalue the business.
- Schedule M-1 on the Tax Return contains important information and business owners tend to not understand how Schedule M-1 works.
Business Valuations are exponentially more accurate if a Valuations Expert or CPA gathers, assimilates, and inputs the critical information pertinent to the engagement to get an accurate value for the business.
The second consideration applies to financial advisors who refer clients to a third-party valuation service and allow their clients to input sensitive financial information themselves. One main reason for a Financial Advisor to not want to refer a client to a self-valuation service like BizEquity is the client’s data is captured by the provider and that data is sold to competitors. Financial advisors often pay for the service, send clients to the service provider, and their clients’ personal financial information is resold by the business valuation service provider to anyone who wants to purchase it. It doesn’t make sense to give competitors sensitive client information, especially when an advisor is paying for the service.
I recommend that a business owner contact a knowledgeable valuation expert who is an independent third party to get an accurate estimate of value for their business. If a client inputs the financial information themselves it is highly likely to produce an inaccurate value for the business.
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.