Understanding the value of the company is the essential first step for owners contemplating the sale of their business.
Many methods and metrics can determine a business’s value. One such metric is EBITDA – Earnings Before Interest, Taxes, Depreciation, and Amortization.
EBITDA stands as a cornerstone for assessing a company’s potential operational performance.
The figure represents the business’s ability to profit by removing the influencing factors from external financial decisions. If a company doesn’t report EBITDA, it can be easily calculated from its financial statements.
In this blog, we delve into the significance of EBITDA and its add-backs, shedding light on their role in accurately reflecting a business’s true earnings potential.
Understanding EBITDA Add-Backs:
EBITDA add-backs are adjustments made to the figure to present a clearer picture of a business’s true earnings potential when searching for its value. These adjustments carefully exclude expenses or non-operating items that may distort the company’s operations.
Making the correct adjustments is critical in achieving the best price for your business.
It is important to note these adjustments could have a positive or negative effect on the value of the business. Many buyers will scrutinise these adjustments to detect if any stretches of the definition have been extended.
Excluding all of these items keeps the focus on the cash profits generated by the company’s business.
Best Practices for Add-Backs:
– Identify significant add-backs carefully.
– Proactively address negative add-backs.
– Engage an M&A professional for add-back identification, validation, and quantification before bringing the business to market.
Positive Adjustments: Enhancing EBITDA Figures
These adjustments get added back onto the EBITDA amount as they are not recurring expenses and do not impact the business’s future performance. These adjustments usually fall under two categories:
1. Once-Off Expenditures:
– Example: Legal fees and restructuring costs.
– Explanation: Eliminating these non-recurring expenses ensures that EBITDA reflects the business’s typical operational performance without the impact of exceptional circumstances.
2. Personal Disbursements:
– Example: Personal expenses of Founder(s) like motor vehicle costs and international travel.
– Explanation: By excluding personal expenditures, EBITDA becomes a more accurate representation of the company’s core profitability, enhancing its appeal to potential buyers.
Negative Adjustments: Capturing Authentic Earnings
Negative adjustments reduce the value of the EBITDA and show the company may earn less than these figures in the future. They usually come either of the following:
1. Related-Party Expenditures:
– Example: Founder CEO forgoing salary or below-market rent paid to a Parent Company.
– Explanation: These adjustments encapsulate the authentic earnings of the business by accounting for related-party transactions and avoiding artificial reductions in operational costs.
2. Non-Operational Earnings:
– Example: Extraordinary gains from asset sales or insurance recoveries.
– Explanation: Ensuring that non-operational earnings are accounted to prevent an inflated perception of profitability.
The Role of EBITDA Add-Backs in Valuation
For business sellers in Australia, EBITDA add-backs are pivotal in influencing company valuation. Potential buyers often assess the attractiveness of an acquisition based on the projected cash flow that the business can generate.
EBITDA serves as a proxy for cash flow, allowing for a standardised comparison of businesses on a like-for-like basis.
Proactively identifying negative add-backs before taking a business to market builds trust with buyers, reduces the risk of valuation discounts, and limits the potential for re-negotiations during due diligence, as you have shown the most accurate representation of production value.
A good rule of thumb is that if the company incurs the identified add-back expenses post-acquisition, they are likely not legitimate.
Let us show an example of how this can impact your valuation. If your financial statements display an EBITDA of $8.6M and you have identified your industry multiple as 7.5, this is how add-backs would change your business sale price:
Valuation Before Add Backs = 7.5 x $8.6m = $64.5m
Valuation After Add Backs = 7.5 x $9.8m = $73.5m
Value Created for Shareholders = $9.0m
Engaging an Experienced Advisor
Given the significant impact of add-backs on sale value, engaging an experienced advisor becomes crucial. Advisors carefully review and understand a company’s accounts to ensure that all add-backs are accepted by potential buyers, optimising the valuation process.
Importance of Precise Add Backs in Valuation
As owners prepare to sell their businesses, a nuanced understanding of EBITDA and add-backs is indispensable.
An accurate representation of a company’s true earnings enhances its appeal to potential buyers and ensures a fair valuation.
Business owners must recognise that potential buyers often scrutinise EBITDA closely, and any misrepresentation can lead to undervaluation or, worse, failed negotiations.
By mastering these financial intricacies and engaging expert advisors, business owners can unlock the true potential of their businesses and secure the best possible valuation in the market.
Elements Advisory Group understands the significance of add-backs in the valuation process. We can provide the most accurate calculations and maximise your business value.