Justifying Your EBITDA
A business owner often decides to sell, only to learn several harsh realities. For example, business owner often discovers that their lack of financial data is a significant problem. The simple fact is that prospective buyers will dive in and scrutinize every aspect of EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) when looking at their perceived value of your business. This will most likely occur through a Quality of Earnings Analysis Report (Q of E). General Accepted Accounting Principles serve as the critical basis and language for financial reporting (GAAP Accounting). GAAP Accounting and Reports often represent a marked departure from how many companies handle their general and day-to-day accounting. The result of all this can be a substantial shift in EBITDA compared to the actual number.
Potential buyers will ultimately receive numerous documents outlining your business’s financial and operational health during the due diligence process in acquiring a business. As a business owner, you must be ready to invest a good deal of time in disclosing as much accurate information as possible to support and defend your business’s objective and precise EBITDA. In short, preparing your business to be sold is no small affair to ensure that information is fully disclosed and in defense of the actual quality of financial and operational health to provide the highest and best acquisition price.
EBITDA is one of the most common ways to value a business based on multiples of that number. When engaging your business for acquisition in the open market, you should expect any buyer or potential investor to review your income statement for adjustments to arrive at an adjusted EBITDA that makes sense for THEM.
You need to be ready and fight back as to what the actual Adjusted or Normalized EBITDA is, which serves as the basis for a purchase price of your business, creating a value used with a multiple to negotiate a final price and terms that make sense for both parties. For example, you missed out on the correct EBITDA for your business by $100,000 on a three multiple, and you just gave up $300,000 in the acquisition cost of your business.
There are three common EBITDA adjustments:
- First, items related to conversion are based on GAAP accounting; this number can have a considerable range.
- Second, one-time events such as legal expenses, PPP loan forgiveness, insurance settlements, and unusual expenses associated with issues/growth of the business can significantly factor into an adjusted EBITDA amount.
- Third, certain personal expenses a business owner takes that would typically not be part of the future cash flow of your business is another potential impact on EBITDA.
Not ignoring balance sheets when representing your business’s financial health and aspects is essential. Smaller businesses typically focus strictly on profit, which can result in balance sheets not being reviewed as often as they should be. The result can be items popping up during due diligence, causing hiccups in deal-making and negotiations. A balance sheet needs to be recast, so the potential buyer truly understands the assets and liabilities conveyed in a sale. It is better to recast the balance sheet upfront to what truly represents the business.
For example, we often see business owners park large amounts of cash in their business and on their balance sheets over and above what is ordinarily necessary. The minute a potential buyer sees a $1,000,000 cash position on a business when a $60,000 working capital position is needed, they will want that $940,000 cash to convey with the business. That’s fine if they are willing to pay $940,000 more for the business but not if they want the sale price of the business on a “cash-free, debt fee” basis when the business conveys to stay the same with a reasonable sale price.
The same is valid with liabilities. Suppose you intend to convey the business without debt. In that case, if $500,000 in liabilities is relieved from the business, the value and burden of debt on the business logically increase by an adjusted amount in cash flow that is not needed by the business moving forward. This mathematically (and logically) increases the value of the business based on the cash flow used against the multiple used for valuation. Relieving $100,000 debt service to the business against a three multiple for the value equates to an additional $300,000 in value and price the business should sell.
There are three key points that business owners should keep in mind when they are planning on selling their business:
- Ensure managers and key employees can step in and run the business during the transition period.
- Review your financials, and get ready for GAAP reporting requirements during due diligence with a potential acquisition.
- Consider having a Quality Earnings analysis performed with your business before going to market, so you genuinely understand the financial health of your business.
As this article underscores, selling a business involves numerous moving parts. Well-organized and solid financials – defensible EBITDA and operational health, represents to buyers and investors a sound and well-run business with an owner that is professional and realistic in their expectations.
Bottom line? Even if you believe it will be years before you place your business on the market, it is never too early to begin preparing.
Copyright: Business Brokerage Press, Inc.
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