Adjusted EBITDA: An Important Business Sale Metric
Updated: Nov 30, 2020
If you are a business owner hoping to exit your business within the next five years, there is one important company metric you should be tracking: Adjusted EBITDA.
External buyers and financial analysts will often use adjusted EBITDA to determine their offer price. If you want to maximize your business price at sale, you should have this number handy and know how it has been trending over the last 3 years at a minimum.
So, what is Adjusted EBITDA? To answer that, we first need to review what EBITDA is. EBITDA is an acronym that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is calculated by taking Net Income and adding back the interest expense, taxes, depreciation expense and amortization expense. It is an approximation of the company's earnings power. It ignores debt, tax structure, and depreciation and amortization because these are based on the current owner's financing and tax situation, and each buyer evaluating the company will have their own unique situation. Using EBITDA allows potential buyers to use an apples-to-apples valuation approach when analyzing multiple companies and submitting offers.
Adjusted EBITDA then, takes the standard EBITDA and adjusts it further to estimate the earnings power of the company if it were acquired by a new owner. What do we mean by that? Well, many small companies will have various expenses running through the company that benefit the current owner(s) but that might not make sense for an external buyer. For example, one of the current owners may own the building as a separate business entity and charge the company above-market rent for use of the space. If an external buyer bought the company, they would not be willing to pay this above-market rent. The difference between the market rate, and the rate you are paying, should not be included in the EBITDA used for evaluating the company. Thus we would have to adjust the EBITDA to remove this difference. That is the essence of Adjusted EBITDA. It is the EBITDA that has been adjusted for any expenses, or differences in expenses, that would not continue if the business were sold to a new owner. This provides a more accurate picture of the company's earning power. Adjustments can be positive or negative. They can include things such as: the owner paying himself below-market/above-market compensation for his position, or having overly generous/meager salaries for family members on the payroll, the company covering the owner's vehicles, travel expenses, professional memberships, etc.
If you intend to sell your business when you exit, it is critical that you track your Adjusted EBITDA for at least the past 3 years, preferably 5 years. You should not share any financial data with any prospective buyer without knowing your Adjusted EBTIDA for each year of financial statements they are requesting. Failure to produce this metric correctly could result in offering prices that are too low, or that are too high (which would be adjusted downwards during the due diligence process prior to finalizing the sale). Neither of these is desirable and could ruin your chances of successfully closing your sale.
Calculating and tracking your Adjusted EBITDA is a key issue we address with our exit planning clients. If you intend to sell your business in the future, this is a metric you should start tracking sooner rather than later. The earlier you start planning and preparing for your exit, the more options you have available to you, and the more time you have to ensure your key metrics, like Adjusted EBITDA, are showing a positive trend sending a positive signal to buyers. To learn more about what it takes to ready your business for sale, please contact us at Augelli Consulting, LLC. We will happily sit down with you for a free consultation to see how we can help you achieve your business exit goals.