Adjustments to EBITDA
When assessing how to value a business for a sale agreement, buyers and sellers typically focus their analysis and valuation of the business on EBITDA over the past few years and expected future projections.
To get the most realistic snapshot of the company’s business, the parties will focus on the analysis and negotiation of adjusted EBITDA as the primary metric.
As we already know, EBITDA analyses the profitability of the business from its core operations before the impact of the capital structure, and takes into account non-cash elements such as depreciation and amortisation. The objective of working on adjusted EBITDA is to eliminate all those expense or revenue items that are not related to the ongoing day-to-day operations of a company.
In the following, we describe some of the adjustments that tend to attract the most attention and also the most discussion by the parties, especially in the environment of family businesses and SMEs:
- Management/ownership salaries and compensation
If the owner’s salary is considered to be above or below market average levels, this is usually eliminated and a salary appropriate to the reality of the company and sector is applied to the income statement. In family businesses, it is also possible to see salaries of spouses or family members who are not active in the business. These salaries should preferably be avoided and if not added to the EBITDA at the time of sale. If the buyer needs to hire new executives to complete the team, there is likely to be a negative adjustment to EBITDA for salary and other items related to such hiring.
- Property related expenses
If the property has personal or business expenses that are unrelated and/or will not continue after the sale, these would also be likely to add to EBITDA. Examples include personal vehicles, insurance, travel, family expenses, etc. …. These items may be in the operating account simply as a tax mitigation strategy.
- Repairs and maintenance
This is often the category that needs the most fine-tuning. Often private business owners record fixed asset investments as repairs and maintenance in order to minimise tax payments, although this practice reduces annual tax payments and may result in a lower valuation of the company for sale due to a lower historical EBITDA. A careful review is therefore required to add or remove from EBITDA any capital expenditure recorded as an expense.
- Start-up costs
If a new line of business has been launched during the period in which historical results are analysed, the associated start-up costs must be added back to EBITDA. This is because these costs are sunk and will not be incurred again in the future. This aspect is always debatable and often leads to disagreements between seller and buyer.
- Rental expenses
If the facilities where the company’s activity is carried out are owned by the company to be sold, it must first be analysed whether the buyer wants to acquire them and, secondly, whether this cost is reflected in the operating account. In case the buyer does not want to acquire the facilities, they should be spun off from the company and EBITDA should be reduced by an industry average rent. Any expenses related to the property (insurance, maintenance, etc. ….) should also be deducted.
- Litigation, arbitration, claims recovery and disputes
Any extraordinary income or expenses that may have occurred during the review period should be deducted or added to EBITDA to normalise it (insurance claims, professional expenses or salaries due to litigation, etc. ….). These are the aspects that we usually detect most frequently, but depending on the activity of the company and its idiosyncrasies, there may be others. Therefore, at AddVANTE, we suggest to all those companies that are considering entering into a sale process that we carry out a thorough study of their operating accounts to detect all those items that may adjust EBITDA and thus determine the fairest value and price of their company.