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Financial and investment professionals operating in the lower-middle market often use EBITDA as a key metric to analyze a company’s operating profitability and determine its value.
EBITDA is calculated by taking the company’s Earnings (E) and adding back Interest (I), Taxes (T), Depreciation (D) and Amortization (A). This post addresses non-customary addbacks, those which go beyond the company’s interest, tax, depreciation and amortization expenses, to calculate EBITDA.
A common method used to calculate business value involves applying a multiple to the company’s EBITDA. And while business owners who intend to sell their business have many options to increase the transaction multiple, one way to unlock value using this calculation is to identify other, non-customary “add-backs” to increase EBITDA.
What Are Add-Backs?
An EBITDA add-back is an expense that will not be included in the buyer’s future P&Ls for the company. Understanding and applying add-backs and other kinds of adjustments helps normalize a business’s earnings on a go-forward basis. This will give all parties a true understanding of the cash flow, and therefore, the true value of the company.
What Are the Different Kinds of Add-Backs?
EBITDA add-backs generally fall into one of the following categories: abstract accounting expenses, interest expense, plus nonrecurring, nonoperating, and personal expenses. Add-backs and adjustments will vary from company to company, but understanding these major categories is helpful in identifying potential increases to EBITDA, and thus business value.
It is important to understand these add-back categories more fully so as to be able to accurately identify EBITDA increases and ultimately a more complete value of your business. Add-backs are also key for a buyer to understand the full scope of financial benefits the current owner experiences.
Abstract Accounting Expenses
Abstract accounting expenses generally include depreciation and amortization. These are abstract expenses that appear on the business’s profit and loss statement, and while they are considered legitimate deductions for accounting purposes, they haven’t truly occurred during the year when EBITDA is being calculated (i.e., there is no actual movement of cash) and subsequently don’t affect the financial benefits derived during the year in question by the business owner. Adding back depreciation and amortization to compute EBITDA is a customary add-back.
How you choose to capitalize a business is completely at the discretion of the business owner and any related interest or late payment fees paid are also an expense that is added back to the net earnings when computing EBITDA. This add back is customary.
Nonrecurring expenses are expenses that are not expected to happen again and are outside of the ordinary course of business. Such expenses often result from one-time, extraordinary events. Some typical examples include:
- Litigation costs
- Professional fees
- Capital expenses
- One-time technology upgrades
- Transaction-related costs
- Facility relocation or renovation expenses
- Bad debt expenses
There is an important consideration here, and that is these expenses are indeed nonrecurring. Clearly, this leaves room for interpretation. For example, if your business is engaged in lawsuits year after year, and such lawsuits are expected to continue, it would be clearly inappropriate to add those costs back, as they are part of the ordinary course of business.
Non-operating expenses are add-backs expenses that are not required in, or related to the true operating performance of the company. Oftentimes, these are related to non-operating assets or liabilities, such as real estate or vehicles. Some typical examples include:
- Discretionary Travel expenses
- Auto allowances for executives and business owners
- Insurance payments for executives and business owners
- Expenses related to leisure activity
Non-operating expenses appear towards the bottom of the company’s income statement. As they do not directly correlate to the business. As such, they are considered an add-back to help the business appraiser or business valuation analyst focus more on the true value of the company.
Personal expenses are often expensed through a business to reduce tax liability. These expenses should be added back because they will end once the business is sold. Some typical examples include:
- Payments to family members who are not actively involved in the day-to-day operations of the business
- Above-market salaries paid to the owners or their relatives
- Bonuses serving as shareholder distributions
- Any expense that is truly personal in nature or discretionary
This category will also include discretionary expenses, such as charitable contributions and food and entertainment expenses. When adjusting for excess compensation, it is important to consider payroll taxes, insurance, and the benefits related to any excess wages.
Despite the name, EBITDA add-backs will not always increase the earnings of your business. Remember, the purpose of EBITDA add-backs is to reflect the true economic earning potential of a business if a third party owned it. Sometimes, negative add-backs are necessary for items that are expected to decrease earnings of the business going forward.
If the business owner personally owns the real property where the business is located and charges below-market rent, the rent expense should be increased to reflect the cost to new owners who will not have the same favorable rent. Or maybe the business owner does not intend to sell all the business’s assets as part of the transaction. In that case, any revenues associated with those assets should be removed to reflect the actual earning ability without those assets.
Factors to Consider
When accounting for add-backs, you will want to analyze the company’s P&Ls for the types of expenses and adjustments discussed above. Be careful not to miss one-time expenses that are easily overlooked. When putting together your add-backs, make sure each one is legitimate and is defendable.
In addition to the various types of add-backs and adjustments, different companies have different ones they must consider. An ESOP, for example, may have add-backs that would differ from a family-owned business.
While adding back (or adjusting) EBITDA is valid in most settings, it’s not ideal to go to market for sale with a significant number of other, non-customary add backs. Generally speaking, when it comes to the number of EBITDA add backs, less is more. Buyers, Investors, PE firms and the like prefer fewer add-backs to EBITDA when considering their investment in your business.
That said, the inclusion of valid EBITDA add-backs create a clear picture of your business’s cash flow which makes it easier to understand how much your business is worth. Work with an experienced professional who thoroughly understands this process to ensure you properly compute EBITDA and ultimately receive the greatest value for your business.