What is High Water EBITDA?

In the world of corporate finance and mergers & acquisitions (M&A), financial metrics are crucial for decision-making, valuation, and performance measurement. One such concept is "High Water EBITDA," which plays an important role in certain financial agreements, particularly in performance evaluations, bonuses, debt covenants, and earnout structures in M&A transactions.

In this article, we will explore what High Water EBITDA is, how it works, and why it can be beneficial or problematic depending on its application. We will also delve into the advantages and disadvantages of using this metric in business agreements and M&A deals.

What is EBITDA?

Before understanding High Water EBITDA, it's important to first grasp the concept of EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a financial metric commonly used to assess a company’s operational profitability without considering its capital structure (debt or equity), tax situation, or non-cash items like depreciation and amortization.

EBITDA provides a clearer view of a company’s core business performance by stripping out expenses that do not relate directly to the day-to-day operations, such as interest expenses on debt, tax payments, and depreciation of fixed assets. It is frequently used in M&A to compare the profitability of companies in a way that is standardized and comparable across different industries and geographies.

What is High Water EBITDA?

High Water EBITDA refers to the highest level of EBITDA that a company has achieved during a specified period. This "high water mark" serves as a benchmark or threshold for performance-based agreements. The concept of High Water EBITDA is often applied in the following areas:

1. Earnouts in M&A Transactions: When buyers and sellers agree on an earnout, which means the seller will receive additional payments based on future performance, High Water EBITDA can serve as a benchmark for determining when and how much additional compensation the seller is owed. The earnout is often tied to surpassing or maintaining a specific EBITDA level.
2. Incentive and Bonus Structures: High Water EBITDA may be used as a metric in executive compensation or employee bonus structures. If a company surpasses its highest EBITDA level during a certain period, executives or key employees may receive additional bonuses or performance-based compensation.
3. Debt Covenants: Lenders often incorporate High Water EBITDA into debt agreements, using it to set financial thresholds for loan covenants. If the company's EBITDA falls below a certain "high water mark," it may trigger penalties or restrictions on borrowing.
4. Valuation: Investors and buyers in M&A often look at High Water EBITDA when assessing the value of a company, particularly if it has shown high profitability in the past. It may influence future payments, earnouts, or even the final purchase price.

How High Water EBITDA Works

To illustrate the concept, let’s use an example. Imagine a company, ABC Corp., that has historically achieved the following EBITDA figures:

• Year 1: $10 million
• Year 2: $12 million
• Year 3: $15 million (High Water Mark)
• Year 4: $13 million

In this scenario, the High Water EBITDA for ABC Corp. is $15 million, achieved in Year 3. This figure now becomes the performance threshold for subsequent years. If the company’s EBITDA surpasses $15 million in future years (say, $17 million in Year 5), the High Water EBITDA shifts to the new highest mark of $17 million. On the other hand, if EBITDA declines (e.g., Year 4's $13 million), the High Water EBITDA remains $15 million.

This figure can be particularly important in M&A deals where earnout payments or bonuses for executives are tied to the company’s future financial performance. For example, in an earnout agreement, the seller may be entitled to additional payments if the company’s EBITDA exceeds its High Water Mark by a certain percentage.

Advantages of High Water EBITDA

1. Motivates Performance: One of the main benefits of using High Water EBITDA is that it provides a strong incentive for management and employees to strive for maximum profitability. Knowing that bonuses, earnouts, or performance rewards are tied to achieving a new EBITDA high motivates teams to focus on improving operational efficiency, growing revenues, and controlling costs.
2. Aligns Interests of Buyers and Sellers in M&A: High Water EBITDA is particularly useful in M&A transactions involving earnouts. It helps bridge valuation gaps by aligning the interests of buyers and sellers. The buyer benefits from ensuring the seller continues to work toward the company's future profitability, while the seller has the opportunity to earn additional payouts by exceeding performance benchmarks.
3. Risk Mitigation for Buyers: For buyers in M&A, using High Water EBITDA as a performance metric provides some protection. They only have to make additional payments to the seller if the business achieves specific, measurable goals, reducing the risk of overpaying for a company with declining performance.
4. Standardized Measurement: EBITDA, in general, is a standardized measure of operational profitability, making High Water EBITDA easy to calculate and compare across different industries. This helps both parties in an M&A transaction or financial agreement to have a clear, objective benchmark to base decisions on.
5. Encourages Long-Term Success: High Water EBITDA ensures that the focus is not just on achieving short-term gains but on setting long-term financial milestones. Companies can continually set new benchmarks for success, encouraging sustained growth.

Disadvantages of High Water EBITDA

1. Pressure on Management: While the motivational aspect of High Water EBITDA is positive, it can also lead to undue pressure on management. Constantly striving to beat the highest-ever EBITDA level may lead to decisions that prioritize short-term profitability over long-term stability, such as cutting essential costs, reducing investments in R&D, or engaging in aggressive accounting practices.
2. Unrealistic Benchmarks: In some cases, the High Water EBITDA mark may be set too high, especially if it was achieved during an unusually favorable market condition. When economic conditions change, a company may struggle to match or exceed its previous performance, making the High Water EBITDA an unrealistic and unachievable benchmark.
3. Potential for Manipulation: When compensation or earnouts are tied to EBITDA performance, there is a risk that management might manipulate financial figures or engage in non-sustainable strategies to inflate EBITDA. This could involve deferring necessary expenses, prematurely recognizing revenue, or delaying capital expenditures to create the illusion of higher profitability.
4. Ignores Other Important Metrics: EBITDA, while useful, does not account for key factors like interest, taxes, and capital expenditures that affect a company’s overall financial health. A focus on High Water EBITDA may cause management to overlook other important metrics, such as cash flow, debt levels, or net income.
5. Volatility in Certain Industries: In industries subject to significant volatility, achieving and maintaining High Water EBITDA can be particularly challenging. Factors like fluctuating commodity prices, economic downturns, or regulatory changes can affect a company’s ability to achieve consistent high profitability, making the metric less reliable in certain contexts.

Conclusion

High Water EBITDA is a powerful financial concept that can provide both benefits and challenges depending on how it is used. It serves as a valuable tool for motivating performance, aligning interests in M&A transactions, and providing standardized benchmarks for operational profitability. However, it also comes with risks, including pressure on management, unrealistic performance expectations, and the potential for financial manipulation.

When applied thoughtfully and within realistic parameters, High Water EBITDA can be a valuable metric for driving business success. However, it’s essential to consider the specific context and industry conditions when using it to avoid the pitfalls that come with focusing too heavily on this singular metric.

Dr. Allen Nazeri, aka "Dr. Allen," boasts over 30 years of global experience as a healthcare entrepreneur. He is the Managing Director at American Healthcare Capital and Managing Partner at PRIME exits. Dr. Allen provides strategic growth consulting to leadership teams of both privately held and publicly listed companies, ensuring their preparedness for successful exits.

He holds a Dental Degree from Creighton University and an MBA in M&A and Investment Banking from the University of Bedfordshire. Dr. Allen is the author of "Value Engineering: Strategies to 10X the Value of Your Clinic and Dominate the Market! " and the brand new book "Selling Your Healthcare Company at a Premium" . Dr. Allen offers a free valuation to business owners ready for a partial or complete exit strategy. Dr. Allen collaborates with strategic buyers, private equity firms, and institutional investors, taking direct accountability for the annual successful sell-side representation of nearly $750M in enterprise value.

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