Selling a business often is a difficult decision for business owners to make, especially for a business owner who has devoted many years of his or her own life developing it, growing it and keeping it viable and successful. Therefore, the decision to sell is both emotional as well as financial.
There are a number of elements that come into play when calculating an appropriate asking price, including financial performance, growth/product opportunities and competitive advantage.
There is one valuation method in particular (EBITDA) that can be a great starting point in determining a business’s value in a transaction. A business owner must take some time to understand how this valuation method will be used to determine the worth of the company.
- What is EBITDA?
EBITDA or earnings before interest, tax, depreciation and amortization is an indicator often used by investors or buyers to calculate a company’s financial performance. EBITDA is calculated by taking non-cash expenses of amortization and depreciation and adding it back to the company’s operating income. Example: EBITDA = Operating Profit (EBIT) plus Depreciation(D) and Amortization (A). By getting the non-operating effects that are unique to each business out of the way, EBITDA can help clear the field by focusing on operating profitability as the primary measure of performance. This is of utmost importance when looking at similar companies across a number of different industries and tax brackets.
- The valuation method using EBITDA
As a key component of a successful transaction, it is important that business owners have a solid understanding of how investors and buyers calculate the worth of their company. Typically, the valuation becomes a multiple of the business’s earnings.
By itself, EBITDA can be merely a statistic. Depreciation and amortization of assets have good reasons behind them. Adding these expenses back to the net operating income can become misleading and can give an incomplete picture of the company’s performance. This is where adjustments to EBITDA come into play.
EBITDA is a non-GAAP figure (Generally Accepted Accounting Principles) and because of that buyers and investors can use their discretion on what to and what not to include in their analysis. Example: Tangible assets might be devalued as old equipment and aging real estate, whereas, employees and management might be considered as intangible assets. Therefore, companies may adjust these items from one reporting period to another.
EBITDA has its limitations and it’s important to understand them, as much as it’s used as a format for evaluating the earnings potential of a business. EBITDA strips out the cash required for working capital and equipment upgrades and therefore cannot effectively measure cash flow. Typically, EBITDA is almost always higher than net operating income and it is used by businesses to window dress their profitability. Also, a company’s customer base and growth potential are not taken into account with an EBITDA calculation.
Thus, business owners should be diligent about their net income, debt payments, changes in working capital requirements and capital expenditures when they are analyzing EBITDA.
- How to strike a deal using EBITDA?
Typically, the EBITDA multiple is about four to six times. However, if a company is experiencing high growth, it can expect a substantial premium that is several times more that the most recent EBITDA. Most often, investors and buyers will initiate or push for a lower multiple and valuation. They will do this by taking an average of EBITDA over the last three to five years as a base for negotiation. Boosting the company’s overall financial performance is the best way for business owners to realize the highest valuation.
To counter this from the onset of negotiations, it is paramount the buyer prepare high quality financial statements, preferably audited financial statements, as a solid first step to focus on. Presenting financial statements that are poorly done sends a message there is a lack of professionalism and or understanding of the business.
Thorough numbers and attention to detail from a value perspective greatly reduce the risk of missing something that might work to the buyer’s advantage and negatively impact the company’s valuation. Making the right changes and adjustments also will have a significant impact on the EBITDA calculation, such as reducing or eliminating unprofitable costs, expanding markets, adding to the product line and increasing sales. For those reasons an owner should always operate his or her company as if they were going to sell.
After implementing all these disciplines in preparation for the sale of the company, it may still be difficult for the buyer to come to an agreement on the purchase price. This is known as a “valuation gap.” In this case, the business owner will have to demonstrate the return on investment and the growth potential, back up and justify the higher multiple on EBITDA.
This can be accomplished by developing a strategic business plan demonstrating the history and performance of the company. In supporting the story, the business owner will have to supply the facts and data to back up their position and communicate that effectively to the prospective buyer.
It has been my experience that if these methods and disciplines are strategically implemented, they will give the business owner strong results.
Bob Wolter is Mergers & Acquisitions Advisor of Creative Business Services/CBS-Global.
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