It is not a surprise that most transactions are based on a multiple of normalized EBITDA. Yes, you do hear from time to time about a multiple of revenue being used instead of EBITDA, but that is usually because the company doesn’t want to give that information away or the company has no profits. Typically, early-stage start-up companies are all valued using revenue multiples.
The EBITDA multiple is widely used to value a business because it is a measure of profit and potential. If you want a refresher on normalized EBITDA head over this blog. I also wrote an entire lesson or two on the topic in my new course: Ready, Set, SELL.
But there are times when it might not be in your best interest to tie the sale of your company to a normalized EBITDA number and, instead, agree on a number that is not tied to EBITDA.
Recently, I received a couple of offers where the buyer gave us a flat number that was not a multiple of EBITDA. In the past, that would have made me a little uncomfortable because I know that the buyer is calculating a number based on EBITDA, so I always want to know what that EBITDA multiple is. In that case, I have to work backwards to try to figure that out.
Here is an example: Recently, I represented a company that was given an offer for $10.420M (cash and equity roll)– pretty random right? Why wasn’t it $10.5M or $11M? So, I backed into the EBITDA multiple based on the data we had given the buyer, and it came up to a multiple lower than we hoped for. After speaking with the buyer, the difference was in part because the buyer didn’t agree with all of our add-backs. They also wanted to add back additional costs for their own back office administration of this new acquisition (payroll, HR, legal admin costs, etc.), which they didn’t want to disclose to us. While not knowing the exact EBITDA value is not uncommon, it does leave you at a disadvantage when it comes time for the Quality of Earnings (QofE) results. What if the accountants find revenue timing issues or mismatching of revenue and expense? Therefore, you really need to find out, as best as you can, what the number is that they are working off of. You also need to figure out at what point the price would change if the QofE comes back with adjustments NOT in our favor, meaning what a “material” difference is in the eye of the buyer.
That all said, there are times when a flat number might be better than a multiple of EBITDA.
Here are a few reasons why you are better off with a “number” vs a multiple of EBITDA:
1. You don’t have GAAP financials
Most companies under $10M in revenue have some modified version of GAAP, but not completely (unless they do an annual audit). Why is a flat number potentially better in this situation? Not having GAAP financials leaves you open to all sorts of adjustments, the worst being revenue you book all at once that your buyer wants to spread over 12 or more months, which could impact your revenue today or your TTM revenue.
2. You will become a tuck-in vs. a stand-alone entity
In this case, the buyer will most likely want to “charge” your company for the HR/payroll and accounting support that they will be providing for you on a go-forward basis. You don’t know what that number is going into the deal, but it WILL be subtracted from your EBITDA as part of the analysis. Of course, this drops your value in a way that might be much larger than what you pay for those services today.
3. You lack some operational maturity
This includes Ticketing and CRM to Sales functionality not being fully operational and integrated. Why? Just like the point above, your buyer will burden you for the costs to integrate or put in place systems that don’t exist or costs they feel need to be incurred. For example, I recently had a transaction where the seller didn’t purchase all the insurance the buyer required, so they hit the seller’s EBITDA number for the cost of those insurance policies. And if you are selling at a 6x to 9x multiple (for example), that means you just lost the value of the insurance costs times your multiple.
4. Flexibility in your salary going forward
There are many occasions where you are either under or overpaying yourself and your buyer wants to set your salary commensurate with others at your level in their organization. Having an upward or downward adjustment of your current salary can have either a positive or negative affect on your EBITDA – usually negative, since most sellers pay themselves a minimum salary and take the rest via a distribution if they are a pass-thru taxable entity. Not having this tied to EBITDA may work in your favor if you are underpaying yourself, as you may be able to negotiate a higher salary and not have it hit as an adjustment.
One situation where an EBITDA value might be better:
If you are a company who does have all your processes and procedures in place, are interested in becoming a platform or portfolio company, AND have done your own QofE in advance (meaning you have had a third-party validate your adjusted EBITDA numbers), I would advise against a flat number unless it goes beyond your multiple expectations. Having a QofE prepared in advance validates your numbers and will most likely point out any GAAP deficiencies you may have, which you can remediate prior to sale. If you plan on being a portfolio company, then the buyer usually sees you as having a good management team and a solid infrastructure in place so you can make additional tuck-in or add-on acquisitions. In that case, what’s to subtract from your numbers, right?
Buyers negotiate deals a number of ways. Regardless of the terms, you may find yourself in a situation where you are just given a flat number for the value of your company. In some cases, that can actually work in your favor, as we detailed above.
What is very important in that scenario is that you set a threshold with your buyer on the tolerance level of downward adjustments they will accept before they change the price.
However, in other cases where you have a solid set of GAAP financials validated via a QofE, you may want to pass on a flat offer if it doesn’t meet your multiple expectations based on your adjusted EBITDA.
Either way, now you know what to look out for!
Want to learn more advanced topics like this? Check out our new course, Ready, Set, SELL (Your Company) and join our waitlist for early notices.