Ever heard of EBITDA? You’re not alone. I’ve found that most entrepreneurs and small business owners haven’t. But that word you’ve never heard of represents a vital concept when it comes to selling your business.
If you want top dollar for your company, you must understand your EBITDA, why buyers care about it, and how you can maximize it. Because I promise you, buyers are going to review your EBITDA as they value your business and make an offer.
The Value Of EBITDA
Before we go any further, let’s define EBITDA. EBITDA, which is a line on your company’s financial statement, is an acronym for “earnings before interest, taxes, depreciation, and amortization.” Buyers focus on it because it can show a more accurate measure of a business’s financial health and overall value than cash profits alone.
Think about it: Multiple businesses in any given industry could have very different cash profits, and those profits don’t always reflect how a business is doing. One business might be actively growing and investing in the future — opening new offices, buying new vehicles, adding new capabilities. These investments drive a high growth rate, but at the same time, they skew the cash profit down significantly. Most of those investments would impact cash profit, but not EBITDA, because they are below that point on the financial statement.
A different business in the same sector, on the other hand, might not be making these investments. In that case, their cash profit will be higher, but that’s because they aren’t actively investing in their growth. That’s not always very appealing to a buyer. Whoever buys the business may have significant deferred maintenance expenses down the road because the company hasn’t made necessary repairs to facilities or equipment.
If buyers valued a business solely on cash profit, the business that was actively investing in growth would have a lower valuation than the one that was not investing at all. However, by focusing on EBITDA, buyers can get some insight into another accurate and normalized indicator of what the business is worth on a comparable basis.
The Three Types Of EBITDA
There are three types of EBITDA: normal (or definitional) EBITDA, adjusted EBITDA and pro-forma EBITDA. As a seller, you should understand each type so you know how to maximize your business’ value to the universe of buyers.
Normal EBITDA is relatively straightforward. It simply considers the numbers as they’re reported without making any adjustments to those numbers.
Adjusted EBITDA, on the other hand, adjusts for expenses that were incurred that won’t occur again or are stated in the wrong period. For example, let’s say you implemented a software program to automate processes that used to be done manually. As a result of this automation, you laid off some employees, but you also gave each of them a year’s salary as severance. That severance is a huge expense, and it lowers your EBITDA for the given period. However, you can raise your EBITDA to a normalized level by adding back those one-time severance expenses to your earnings.
Pro-forma EBITDA is another way to adjust EBITDA, but it’s unique in that it adjusts for things that will happen in the future. For example, perhaps you own a service company, and halfway through the year, you sign a large contract. While you only receive revenue from that project for six months this year, next year, you anticipate a full 12 months of revenue from it. You can adjust your EBITDA up accordingly and get buyer consideration for it as a result.
What Buyers Are Looking For
Generally speaking, in a healthy, growing business, adjusted EBITDA is higher than regular EBITDA, and Pro-forma EBITDA is higher than both. When selling your business, aim to achieve a valuation based on the highest EBITDA possible. However, it can be complicated to capture every adjustment. Because every situation is unique, it may be a good idea to work with an accounting firm to determine your EBITDA.
While EBITDA is important to valuation when selling, it isn’t the only metric people will use. As a buyer of more than 50 companies over the past 20 years, I can attest that EBITDA is one of many considerations. Buyers also look at revenue streams, customer concentration, how businesses are likely to perform during recessions and pandemics, etc. Certain sectors are impacted differently by economic cycles.
Financial metrics aside, the universe of buyers also looks at leadership, culture, growth rates of the industry in which you operate, and more. Suffice it to say that there is a multitude of factors that drive overall valuation, but EBITDA is as important as all the others — so it’s important to be tuned in to what it is, how it works and, like the other factors, present it in the best light.
By understanding EBITDA and working to maximize it before you sell your business, you show the universe of buyers that you are a sophisticated seller who understands the true value of your business. That is how you get the highest valuation and, ultimately, the largest sale price.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.