The CEO's Role in Striking a Credible Adjusted EBITDA Prior To M&A
Walter Adamson
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Owners of a growing private business inevitably face a dilemma in explaining the business's NOPAT performance against their valuation expectations. This is because they have minimised their net income and taxation through clever management and choices.
This tactic is beneficial for owners in the short term but can ultimately lead to problems down the line. While buyers look at many metrics and indicators when considering an acquisition, EBITDA and its sister Adjusted EBITDA are among the most common.
If you're looking at selling your company, understanding these EBITDA metrics and how they affect your valuation is critical.
With this insight, and ideally with sufficient time because you began exit planning well ahead, you can benefit by developing solid skills in managing and explaining your EBITDA and Adjusted EBITDA.
For example, you may be very willing to forgo profit over several years because you are confident that investment in capabilities or R&D or a new strategic partnership, or re-skilling staff will lead to tremendous new opportunities.
Such investment is fabulous for future income but not so good for your current NOPAT and EBITDA. This issue is why understanding how to normalise EBITDA - and actively manage this normalisation - is vital in setting initial buyer price expectations.
Why Does EBITDA Matter?
EBITDA is one of the most common non-GAAP financial measures. As a result, it is widely used to measure the profitability of companies, especially by lenders, and throughout the M&A process.
Despite it not being governed by accounting principles, lenders like EBITDA because it will eventually represent operating cash flow (since it includes the non-cash expenses), which explains why bankers like this metric in loan covenants. If EBITDA is reasonable, the thinking goes, your operating cash flow will follow and the income statement will shine.
Similar to many other non-GAAP financial measures EBITDA is useful for buyers because it provides transparency into the operational efficiencies of your business by eliminating the effect of non-operational factors such as the timing of capital expenditure. It also allows them to analyse and compare your company's financial performance with others in your industry because it ignores the impact of financing and accountancy decisions.
Although the purpose of following an exit strategy is to attract a strategic buyer, i.e. one who will pay a high forward multiple, an EBITDA is the starting point from which buyers will apply a base transaction multiple and a valuation determined.
This multiple then forms an "anchor price" for the buyer. The demanding job of M&A is to bring the focus back to the strategic value and the future earnings potential.
The sooner you, as an owner, bring EBITDA analysis into your regular management accounting and ensure that your other systems, e.g. R&D and project accounting, are correctly classifying EBITDA-related (see below Adjusted EBITDA) expenses the stronger position you will be in to support conversations about valuations.
In a healthy, growing business, Adjusted EBITDA is generally higher than regular EBITDA, and Pro-forma EBITDA is higher than both. This difference is because a growing business typically has higher expenses related to expansion and new initiatives, which can be recast in the Adjusted and Pro-forma EBITDA figures.
Getting on top of EBITDA is a pre-requisite for building out the Adjusted and Pro-Forma EBITDA, which will become part of the sale negotiations for your business.
The importance of the Adjusted EBITDA calculation in business valuation
Adjustments to EBITDA are all called normalisation adjustments. These adjustments remove the effects of seasonality, revenue, and expenses that are unusual or one-time influences. For example, with founder-owned businesses, there may be significant cost items in the accounts that are not directly related to the profitability of the underlying business.
Adjusted EBITDA is a widely used metric in the M&A deal process to assess the "earnings power" or sustainable earnings of the target arising out of principal business activities on a going concern assumption.
It is considered to be a proxy of a likely earnings stream post-transaction.?
There are two broad categories of normalisation adjustments: general normalisation and due diligence adjustments.
General normalisation is the removal of one-time impacts that will not reoccur in the future. This removal results in a more accurate presentation of the income recognised and expenses incurred by the business during a typical year.
Examples of general normalisation adjustments include:
Next, due diligence adjustments are those necessary to reflect a company's financial statements per accounting standards. Common adjustments related to due diligence include:
Why Adjusted EBITDA determination is a business process
When making general normalisation and due diligence adjustments, the main thing is to understand and question the reasons behind them.?This understanding requires investing in analysing company records and procedures to find missing adjustments - both positive and negative.
Decisions about which items to include in the adjusted EBITDA have consequences. The rationale for such adjustments will be challenged by the buyer, and some buyers are extremely wary of EBITDA because they think it can give an inaccurate view of a company's financial health.
This subjectivity is why Warren Buffet famously said, "We won't buy into companies where someone's talking about EBITDA," and explained that he believes that there is a lot more fraud in companies that use EBITDA as a metric than in those that don't.
For example, lost revenue due to COVID-19 is unlikely to be a permissible add-back because the concept of "lost revenue" does not exist in GAAP. On the other hand, from an owner's perspective, one-off costs of doing business due to border closures are a justifiable adjustment.
EBITDA is a profitability measure and does not include any CAPEX. Therefore, for example, if you are capitalising a significant amount of software development under R&D rules, a buyer may deduct this value from your EBITDA. This deduction will show a better approximation of operating cash flow.
On the other hand, a business may have been expensing all R&D and now believes that the positive impact of that R&D on current and future earnings deserves a normalisation adjustment to Adjusted EBITDA. This decision requires rigorous justification from the Owners, the CFO and the company's accountants.
Takeaway
Unlike the EBITDA, which is governed by accounting principles, identifying appropriate normalisations can be challenging and requires significant judgement. Hence while EBITDA is a non-GAAP metric based on principles, Adjusted EBITDA is one further step removed based on business, accounting and commercial judgement.
As mentioned, an EBITDA multiple creates an instant "anchor price" for buyers. And moving upwards from that price to your desired ultimate exit price takes enormous leverage.
Leverage takes work. Daily distractions will draw your attention, focus and effort away from creating and sustaining this leverage during the short game of M&A (the final year of your exit path).
This aspect of due diligence is but one of tens of milestones to complete as you head towards the sharp end of selling your business (see the yellow dot in the Proactive Exit Mastery model). For this reason, pays to embed processes early in your exit path journey.
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To get the best EBITDA multiple possible, you should firstly embed an Adjusted EBITDA Review into your quarterly reporting - including a table of adjustments and their justifications. Then, make this monthly when anticipating a potential M&A transaction. Think of this as a quarterly Quality of Earnings report prepared by your CFO in consultation with you and your external accountant.
You will then be in a perfect position to provide the Adjusted EBITDA rationale for a higher price to a buyer through a detailed explanation, and reinforced by your strategic communication processes.
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This Week's Reading
Two articles from my reading list to help you grow and exit successfully.
Article 1: A Good Deal: Quality of Earnings Are a Critical Transaction Step
When a business decides to sell itself or merge with another company, it needs to provide investors with enough information to make an educated decision. For example, if the buyer wants to invest $50 million in the seller’s business, he or she needs to understand the value of each dollar of revenue generated, the cost of each dollar of expense incurred, and the profitability of each dollar of revenue.
A quality of earnings report is a document that summarises the performance of a business over a given period of time. It includes information about how much revenue the business generated during that time frame; how much money the business spent on operations; and whether those expenses exceeded revenues. It also reports net income, which is calculated by subtracting operating expenses from total sales.
In addition, a quality of earnings report contains information about capital expenditures, such as investments in equipment and buildings. Finally, it contains information about changes in working capital—the amount of money held in inventory, accounts receivable, and prepaid expenses.
Full details and two cases studies are in this article from the Construction Financial Management Association.
Source: cfma.org
Article 2: The Pitfalls of Non-GAAP Metrics
Alternative metrics have become increasingly common in corporate reporting. These metrics are supposed to provide investors with a better understanding of how well a company is doing. But there are problems with relying too much on these metrics. They don't always tell us what we want to know about a company. And some of these alternatives aren't even relevant to many businesses.
In the late 1990s, the accounting profession began to embrace "non-GAAP" metrics. These metrics are meant to give investors a better idea of how well a company actually does. However, there are pitfalls to relying on such metrics.
This article examines the pros and cons of three of the most commonly used alternatives to GAAP earnings and observes that "as companies have become more brazen, the justifications for using alternative metrics can be more elaborate, as reflected in the following examples involving stock grants, nonrecurring expenses, and unwelcome news".
Source: sloanreview.mit.edu
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This Week's 3 Business Books
Free for you as a subscriber to my newsletter: Three of the world's most essential and popular business books in acclaimed 12-minute videos. Listen, or watch and listen to take advantage of another big idea.
Book 1:?Giftology by John Ruhlin (watch on Monday-Tuesday)
This book is all about creating a breakthrough gifting strategy and how you can use it to grow your business.
If you want to fight through the noise, fill a primal need in all of your prospects to feel important, and turn into raving fans and advocates for your business, this book is for you.
Book 2:?Peak by Anders Ericsson (watch on Wednesday-Thursday)
The biggest misconception in self-improvement is that "practice makes perfect." This belief isn't true. Practice, if you are not being deliberate, makes things permanent.
Deliberate practice, on the other hand, has well-defined, specific goals. It also requires feedback and correcting your mistakes. This fascinating summary teaches about what it is and how to do it.
Book 3:?Great by Choice by Jim Collins (watch on Friday-Sunday)
In a methodology similar to Good To Great, Collins and his team studied companies that were in industries where there was a constant state of change and found that some companies outperformed the marketplace by a significant margin.
He called these the 10X companies. They all had outperformed their "industry index" by more than ten times over the span of the study. In fact, on average, the 10X companies outperformed the marketplace as a whole by 32 times. Learn why.
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Keep winning, Walter
P.S.?If you know you’re ready… it might be time to explore my?Proactive Exit Mastery?model, to see how you might capture the ultimate exit value for your business.?If you'd like to know a bit more, just message me or comment below with "Ultimate Exit Value".
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