By W. Coleman Powell, FHFMA, CPA
In middle market mergers and acquisitions, buyers and sellers sometimes establish target prices based on multiples of EBITDA—Earnings Before Interest, Taxes, Depreciation, and Amortization. Even where EBITDA multiples are not explicitly used to calculate the purchase price, offers are often made contingent on the seller achieving or maintaining an EBITDA target. Valuations expressed as a multiple of EBITDA are often quoted by lenders, investors and investment bankers in corporate finance transactions. As such, the calculation of EBITDA has the potential to become an issue in many transactions.
In a transaction where the nominal purchase price is to be determined as a multiple of EBITDA, it is important to keep in mind that that buyer sets the multiple of EBITDA in the offer, but that the seller calculates the EBITDA subject to the buyer’s financial due diligence.
In theory, the earnings that matter to sellers and buyers are the operating cash flows of the selling company less routine capital expenditures. While EBITDA is a widely accepted measure of cash flow, it is not defined in Generally Accepted Accounting Principles (GAAP). Because there is no strict definition of EBITDA that is accepted throughout the accounting and financial professions, the calculation of EBITDA can present issues that need to be considered.
When evaluating EBITDA it is important to consider the time period. Multiples can be applied to historical EBITDA, pro forma EBITDA for the fiscal year of the transaction, budgeted EBITDA for the fiscal year following the transaction, expected EBITDA for immediate twelve months following the proposed transaction, or for some other period. The period whose EBITDA is used to determine the nominal transaction price can make a substantial difference in the ultimate transaction value. For example, a company with declining sales and profits could be overvalued if using historical EBITDA, while one with increasing sales and profits might be undervalued.
Another issue is the basis of accounting used by the seller. Larger companies are more likely to use the accrual basis of accounting. In this situation, a recent report from an independent auditor adds credibility to the seller’s EBITDA calculation if the financial statements are prepared in accordance with GAAP and were audited in accordance with Generally Accepted Auditing Standards. Other reports to the board may disclose significant deficiencies, material weaknesses in internal controls, and disagreements with auditors. These disclosures are instrumental in understanding financial statement error risks and assessing EBITDA. Alternatively, the seller may use a non-GAAP methodology such as an Other Comprehensive Basis of Accounting (OCBOA) commonly referred to as the modified cash basis of accounting or cash basis financial statements for income tax purposes. Although less complex than GAAP financial statements, OCBOA financial statements allow for subjectivity in the recognition of revenue and expense reporting, to name a few areas of concern, and can have a profound impact on EBITDA.
Buyer and Seller EBITDA Adjustments
Adjustments made to reported EBITDA from the financial statements can have a dramatic effect, significantly increasing or decreasing the ultimate EBITDA figure. If the multiple remains constant, the impact may result in a corresponding increase or decrease in the price the seller will receive. Following are several examples of these adjustments:
- One-time expenses for professional fees, severance expenses, inventory write-downs, acquisition and restructuring costs
- Non-cash stock compensation expense
- Normalizing salary expenses if excessively low or high
- Recording period expenses
- Proper revenue recognition and cutoff
- Settlements and non-recurring revenue or expense amounts
- Corporate expenses
- Department or division carve-outs
- Owner compensation and discretionary expenses
- Lost or new customers
- Discontinued operations
- Fraud or regulatory issues
- Lease treatment and equipment capitalization issues
- Required capital expenditures for the next two to three years or the lack thereof
Sophisticated sellers, or sellers using financial advisors with relevant transaction experience, analyze reported EBITDA to develop adjustments, providing them to the buyer in advance of the offer in the form of an information memorandum. The buyer is then able to perform due diligence on the adjusted numbers and consider this information in the development of the offer. On the other hand, less sophisticated sellers, those who have difficulty supporting unadjusted EBITDA, and those who are unwilling to be transparent and provide credible information are at risk of having offers withdrawn or reduced during due diligence. In addition, these sellers often leave money on the table by not identifying favorable adjustments.
Practical Considerations When Using EBITDA Measures
- Evaluate the multiple itself. Is it simply an industry comparison that has been cherry picked by the buyer? What are these comparisons and how have the risk-return assumptions been considered?
- Determine the EBITDA measure that has been applied to the multiple to derive the value. Was a historical or future earnings measure utilized?
- Identify the basis of the EBITDA measure. Is it an annualized period or an actual twelve month historical or budgeted period of time? If budgeted, are the assumptions reasonable? Is the budget process reliable and realistic?
- Evaluate the basis of accounting. Do the financial statements follow GAAP or OCBOA guidelines? Is the basis of accounting identified in the indication of interest letter? Is the accounting consistent with historical financial reporting or has it been modified to change EBITDA?
- Reconcile the components of EBITDA, before buyer and seller adjustments, to the financial statements. Are the appropriate items included in earnings? Are disclosed non-operating revenues and expenses excluded? Does interest solely relate to interest bearing debt or have merchant fees and bank charges been included?
- Note and categorize seller and buyer adjustments. Are these adjustments significant, accurate and complete? Do these adjustments make sense?
- Identify possible adjustments that have not been quantified. Do these issues create significant additional risk, uncertainty or could they reflect opportunities that may not have been properly considered?
- Document the analysis and adjustments. Will this information be used in future negotiations? Is the analysis complete? Can the figures withstand scrutiny?
In summary, sellers and buyers should familiarize themselves with the nuances of EBITDA calculations. A transaction with an attractive multiple might not be a great deal for the seller if that multiple is not applied to an appropriately calculated cash flow. Similarly, a low deal multiple will not protect a buyer from a bad deal if the multiple is applied to an unrealistically optimistic measure of EBITDA.
Rather than relying on rules of thumb, we encourage our transaction clients to engage in a comprehensive valuation process that considers the market for the company, the entity’s earnings potential, the risk and the possibilities for growth associated with those earnings, the value of the company’s assets and liabilities, as well as other factors. The professionals at Decosimo Advisory Services are well versed in the determination of the value of businesses prior to the transaction and in performing due diligence after an agreement has been reached. We can help you determine the best courses of action. If you have questions regarding a transaction or due diligence matter, please call us in confidence at 800.782.8382 or email us at email@example.com.