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You are here: Home / Uncategorized / The importance of understanding “Adjusted EBITDA”: Revised for COVID 19

The importance of understanding “Adjusted EBITDA”: Revised for COVID 19

October 26, 2020 //  by Linda Rose

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UPDATED

A couple of years ago, after selling my last company, I wrote this post on “adjusted EBITDA”.  In my initial blog post, contained herein, I listed a number of adjustments to EBITDA as it pertained to my business and typical adjustments in general. Fast forward a couple of years, and a few transactions I completed for clients, I now have a broader list that I would like to share.  Also, since four of my clients sold during this COVID pandemic, more adjustments have come to light given our current climate. Below is the original post with updates.

If you are a business owner, I’m sure you are familiar with EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). This is considered the traditional valuation method that measures a company’s historical cash flow generation. Usually a multiple of this number (depending on the type of company) is used to value a company – anywhere from 3x to 12x in the Microsoft technology space, unless of course you have your own IP then valuations can be north of 15x.

And size matters: If you are over $25M in revenue, anticipate higher multiples in the 10x – 15x range – this higher range is attributed to businesses with strong recurring revenue and those with their own IP. That said, this multiple-based calculation is not necessarily reflective of the potential total value of one’s business, and on many occasions the final transaction value exceeds any standard valuation as the buyer views the ultimate value to be in the future potential of the company and not the historical past. We have all witnessed purchases in the last couple of years that are out of the normal range.

As I outlined earlier, while EBITDA is a starting point, it is just that, a starting point.  Additional add-backs in for the form of other normalizations are where the true adjustments lie.

In both of my transactions I calculated a number that was considered an “adjusted” EBITDA. Adjusted EBITDA is revised to exclude the effects of mainly non-recurring items of revenue or gain, and expense or loss. It can also include items that are directly related to the owners running the business. Examples of adjusted EBITDA items are as follows:

Add backs to your EBITDA number: (increases your value)

  • Excessive owner salary: Owners earning far above the industry norm;
  • Owner Bonuses: Amounts per rata beyond what other employees are receiving;
  • Profit Sharing: Owner profit sharing or 401K beyond a normal 3% match, etc;
  • Automobiles/Housing: While completely legal, the buyer would likely not embrace moving forward;
  • Insurance (i.e. owner’s health, auto, life, key man, disability);
  • Owner Travel: If excessive between locations
  • Legal Expenses: Perhaps due to a one-time lawsuit.
  • Contributions: Owners many times have their favorite charities which may be considered a more personal item.
  • Sporting events, box seats, etc.: Many owners buy annual box seats or tickets for big sporting events as much for personal as business reasons.
  • One-time investments that should have been capitalized
  • Intercompany expenses: One holding Company paying the other for a variety of reasons
  • Extraordinary losses: Such as unusual customer bankruptcy.

Subtracts to your EBITDA number: (decreases your value)

  • Less than normal owner salary – the add-back might be the difference on what you are earning and what your replacement might cost.
  • Not have adequate benefits in place for your company – this is usually not the case, but those will be reviewed in detail.
  • Owner leaves but has also been a key player in sales – the salary of a salesperson may be a subtracted based on the need to hire a replacement.
  • Extraordinary gain – i.e. one-time sale of IP that will never happen again.
  • Fair-market value rent adjustment:  Especially if the office space is rented from the owner.  This adjustment could go either way if the rent is deemed “excessive”.

Covid Adjustments

New EBITIDA adjustments are now coming to light with COVID.  These can both be add-back and reductions to EBITDA depending on the adjustment.  Here are a few you might want to look out for:

Adds:

  • IT expenses incurred to accommodate remote workers
  • Hardware/software to increase security/bandwidth for remote accessibility. 
  • Temporary price reductions in hourly rates, fees, services, product discounts.
  • Costs associated with the office to allow employees back. (i.e. Cleaning, additional space, furniture, down-time, etc.
  • Severance costs for terminating employees, or re-hiring costs to bring people back
  • Outside professional services such as legal costs to review leases, severance agreements, HR manuals, etc.

Subtracts:

  • Reduction in rent that is temporary, (not permanent).
  • Other temporary reduction in expenses.

While this list is not exhaustive by any means, it does give you an idea of what you might look out for as you look at your financials in 2020 and beyond. What is important is if you do plan on a potential sale in the next 3 years, to begin tracking these adjustments now as they be harder to capture later, or worse, may be forgotten altogether.

A complete downloadable spreadsheet with examples is available upon purchase of my book, Get Acquired for Millions – A Roadmap for Technology Service Providers to Maximize Company Value.  A worthwhile investment since just one of these adjustments can add hundreds of thousands to your sale proceeds.

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