The use of EBITDA to value a business may sound simple in theory, but it is essential that sellers thoroughly understand this calculation, as making these normalizing adjustments and “add-backs” to the historical EBITDA can directly impact the valuation that prospective buyers will initially put on their business.
By Michael Hannon

When assessing how to assign a value to a lower middle-market business (i.e., companies with annual revenues ranging from $5 million to $150 million), most prospective buyers will typically focus on Adjusted EBITDA as their primary valuation metric. To define the term, EBITDA is an acronym for: Earnings Before Interest, Taxes, Depreciation and Amortization expenses.

Many sellers mistakenly believe that the annual revenue, bottom-line net income and/or balance sheet asset values are what drive the buyer’s valuation of their business. However, this is rarely the case, unless there are unusual circumstances that might warrant such an approach.

To calculate a base valuation for a business, buyers will instead start with the historically reported EBITDA generated by the business (typically for the prior 12 months), before making various normalizing adjustments and “add-backs” to arrive at the Adjusted EBITDA. Buyers then apply a multiple to this Adjusted EBITDA amount to arrive at a base valuation for the business.

It is important to note that the specific EBITDA multiples used by individual buyers will vary from year-to-year, generally driven by what is going on with the overall national economy:
• Period of economic growth vs. recessionary
• Interest rates
• Stock prices of the buyer
• Supply and demand of available businesses to acquire
• EBITDA multiples currently being used by competitive buyers
• Generally, how aggressive prospective buyers have chosen to be in executing their strategic growth plans

For advice on the current EBITDA multiples being paid by buyers, it is best to seek out a qualified M&A transaction advisor who specializes in performing business buy-sell transactions in your industry.

Understanding EBITDA
The use of EBITDA to value a business may sound simple in theory, but it is essential that sellers thoroughly understand this calculation, as these normalizing adjustments and “add-backs” directly impact the valuation that buyers will initially put on their business, and are sometimes aggressively negotiated between the sellers and buyers as part of the process of completing the business M&A transaction.

EBITDA can easily be calculated directly from the historical financial statements of the business. More specifically, EBITDA is calculated as:

Operating Income + Depreciation + Amortization

The Operating Income figure can be found on the Income Statement, while Depreciation and Amortization expenses are located on the Statement of Cash Flow. It is important to note that Operating Income is not to be confused with Revenue or bottom-line Net Income. Operating Income is calculated as follows:

Revenue – Operating Expenses – SG&A Expenses = Operating Income

Note that Operating Income specifically excludes Taxes, Interest, and other non-operating items such as gains or losses on asset sales, because these costs are deemed to be non-core to the business. By adding back Depreciation and Amortization (both non-cash expenses) from the Statement of Cash Flows, buyers will arrive at the EBITDA amount that represents the company’s cash earnings. While this measure may not be perfect, EBITDA is, in fact, a widely accepted business valuation metric.

M&A professionals commonly use EBITDA for business valuation purposes because they are trying to determine the earnings power of the business on a “going concern” basis, irrespective of taxation and financing factors (i.e., tax and interest expenses are excluded from EBITDA). This is the case because each buyer will have their own unique financing and tax circumstances, so these items are not taken into account when calculating the base valuation of a business.

Normalizing Adjustments
After calculating the EBITDA being generated by the business (using the most recent trailing 12-month financial statements) buyers will then apply various normalizing adjustments and “add-backs” to EBITDA to arrive at the Adjusted EBITDA. Determining the amount(s) of these adjustments is particularly important because it goes directly to what a buyer will likely pay for the business. Simply put, most of these adjustments reflect expense items that are currently being recorded through the Income Statement (therefore reducing the historically reported EBITDA), but will not continue to be realized or recorded as expenses after the transaction is closed, thereby increasing the post-acquisition EBITDA.

Therefore, the Adjusted EBITDA figure is a representation of what the earnings stream of the business will likely be on a going forward basis (i.e., under the ownership of the buyer). So, if certain expense items will cease immediately after the deal is closed, they are assumed to be zero by the buyer in their financial projections (hence, they are added back to historical EBITDA). A common example of this is an owner’s salary and any other personal expenses which are directly associated with the owner(s) and are being recorded on the Income Statement. Some other common normalizing adjustments or “add-backs “are discussed in more detail further below.

A simple example of an “add-back” might include a $50,000 expenditure that was made for a one-time, non-recurring legal fee, which could add $400,000 to the transaction value (assuming an EBITDA multiple of 8x). The reason for this is because the “add-back” increases Adjusted EBITDA by $50,000 and, hence, the valuation by: $50,000 x 8 = $400,000. In practice, there may be some give-and-take with both the “add-back” amounts and the EBITDA valuation multiple being used, but, otherwise, it is a straightforward calculation. An experienced M&A transaction advisor can help a seller navigate this process.

Clients are also advised to be forthcoming and realistic about negative adjustments to EBITDA. These negative adjustments typically take the form of new expense items to the buyer that will reduce the EBITDA generated by the business going forward.

Examples of this might include the necessity to hire a new employee to fill an important position that was previously vacant, or, incremental expenses related to the buyer implementing a new safety program so the business they are acquiring will be following the higher safety standards that may be practiced by the buyer. Such items would be new expense items to the buyer after the deal is closed and will, therefore, reduce the EBITDA of the business going forward.

Normalizing adjustments (both positive and negative) are used so that buyers can determine the underlying earnings capacity of a business (post-transaction). In summary, these items will generally include various discretionary, non-recurring and owner-related expenses. Following are some of the more common Normalizing Adjustments to EBITDA.

Owner Salary and Compensation: A business owner can directly control the amount of their salary. If this salary amount is deemed to be above current market levels, an “add-back” for any excess salary would be appropriate (along with the associated payroll taxes). One may also need to adjust for spouses or family members that collect a salary, but may not be actively involved on a day-to-day basis in running the business being sold.

Other Owner-Related Expenses: If the owner has personal or business expenses that are deemed to be inordinately high or will be eliminated after a transaction is closed, the amount of these expenses should be added back to the historical annual EBITDA. Some examples of other expenses to be included as “add-backs” are:
personal vehicles, health insurance, officer life insurance, unusually high travel, and entertainment and club memberships.

Property Rental Expenses: The seller may own the buildings and real estate in a separate legal entity. If this results in the company paying above or below-market rent, the income statement should be adjusted accordingly to reflect a fair market rent level. Even if the properties being rented are not owned by the seller, if a buyer determines that a lease reflects under-market rent levels (and it is not assumable or assignable), they will make a similar adjustment to EBITDA.

Other Real Estate Considerations: Adjustments would also be made if the real estate is owned by the business, but it is not critical to operations. In this case, if the buyer does not intend to use this property, any real estate expenses (insurance, maintenance, etc.) would be removed from EBITDA and the real estate would be valued separately from the business. When doing this, it is important to remember to also adjust the business income statement (negatively) to reflect a market rent expense.

Gaps in Management Organization: Is the existing management team well-rounded and deep, or is it largely driven by the owner-operator? If a buyer must hire new individuals to fill out the management team due to the owner’s departure post-closing, there would likely be a negative adjustment to EBITDA for salary, benefits and other items related to the new hires.

A common example is when a bookkeeper is the only financial manager, where a more experienced financial executive such as a certified accountant or controller may be necessary post-transaction. An honest acknowledgement of any management gaps by the seller, helps build early credibility with potential buyers.

Professional Fee Expenses: This category includes third-party accounting fees, legal fees, consulting fees and/or engineering fees. For example, if the business has been undergoing any one-time or highly unusual lawsuits; it would be appropriate to include the historical expense associated with these items as “add-backs”. However, this would not include typical ongoing legal expenses that are common to most businesses. Also, in many cases certain practices will cease being performed by third parties after the transaction closes and be absorbed by the buyer’s current corporate infrastructure (i.e., the buyers existing accounting department, engineering staff, legal staff or professional departments already in-place). In such cases it may be appropriate to also include the expenses previously paid to mprofessional third parties as “add-backs” to EBITDA by the seller.

Other Miscellaneous Expenses: This may include any number of extraordinary items such as insurance needs or upcoming premium changes (positive or negative), upcoming wage increases (negative), fire or natural disasters that caused one-time expenses for repair (positive), a one-time building renovation or repair cost (positive), non-GAAP or unusual accounting practices (positive or negative), and deferred capital expenditures/maintenance on equipment (negative).

Get Into Discussions Early
This discussion only touches upon a few of the items that can go into normalizing adjustments and “add-backs to be made when calculating the Adjusted EBITDA of a business to be sold. For example, any cost reducing synergies that will be created as a direct result of the businesses being combined has been given little attention here, while these cost savings can often add great value to a transaction due to the increased EBITDA to be realized by the buyer post-transaction. Common types of cost reducing synergies include:

• Savings in overhead costs to be realized by the buyer (both in labor and facility operating costs) as a direct result of the buyer eliminating one of the operating facilities and combining them into one post-transaction
• Cost savings the buyer can realize by initiating route reductions because the combined businesses are able to consolidate routes for improved route density/productivity (i.e., resulting in EBITDA improvement)
• Ability a buyer may have to redirect waste volumes from the disposal facilities previously used by the seller, to their own company-owned facility and thereby earn new incremental EBITDA at the buyer’s disposal facility.

A full discussion of how synergies can affect projected EBITDA is better left for another article, as there are many examples that can be cited, and these are often dependent on the specific market conditions and other unique circumstances. Again, a well-qualified M&A transaction advisor with strong experience in your industry can help in identifying and quantifying such situations.

In any event, we trust that this information provides sellers with a good understanding of what the basic business valuation process entails. We underscore the importance of getting this calculation correct and not missing items that could impact the business valuation, whether positively or negatively. Therefore, we always address the Adjusted EBITDA and other key business valuation topics early in our discussions with prospective M&A transaction clients. | WA

Michael Hannon is the Founder, President and CEO of Valuation Insight, a professional M&A Transaction Advisory Services firm providing its services to the owners of lower middle-market privately-owned companies (for sell-side transactions), as well as to large regional companies, publicly traded companies and private equity firms (for buy-side transactions). Michael has accumulated more than 40 years of experience while completing hundreds of M&A transactions for businesses primarily in the waste and recycling industry, with particularly strong expertise with businesses involved in waste collection, waste disposal and recyclable materials collection and processing, and confidential document destruction. For more information, call (940) 230-3841, e-mail mhannon@valuation- or visit