Calculating EBITDA

If you’re like most business owners, you’ve operated your company in a manner to minimize taxes. You may have given yourself and your family members as many perks and benefits as possible, kept non-working family members on the payroll, and written off other expenses through your business – all of which contribute to decreased earnings and, therefore, a lower tax burden. These, and other common practices, are designed to keep your profits and your taxes low, perhaps artificially so.

All well and good. But when the time comes to value your business, these expenses must be removed before you can accurately value it. Financial statements form the basis of all business valuations and must be “normalized” or “adjusted” before you can get a true reading. The process of normalizing or adjusting your financial statements involves making numerous adjustments so that the actual earning capacity of your business can be properly measured. 

Common adjustments include the following:

• Your salary and perks
• Family members’ salaries and perks
• Expenses or income that won’t recur or continue after the sale
• Personal expenses, such as personal auto, insurance, cell phone, child care, medical, and travel expenses
• Depreciation
• Amortization
• Investment or other non-operating expenses or income
• Interest payments on any business loans
• Other one-time or non-recurring expenses
• Non-operating revenue

Removing owner-specific perks, benefits, and expenses is necessary to determine your business’s actual earning capacity. Adjusting your financials in this manner allows you and potential buyers to compare your business with other businesses using EBITDA, which is the most common metric for valuing companies in the middle market.

Adjusting your financial statements is one of the most important steps in valuing your business. Many buyers compare potential acquisition targets using EBITDA. By comparing the EBITDA of one company with another, buyers can easily understand a business’s value based on the business’s generated profits rather than its taxable income. This normalization helps facilitate a more accurate comparison between companies.

Let’s get ready to do some normalizing …

Adjusting your financial statements is one of the most important steps in valuing your business. 

Definitions of Adjustments 

Here are descriptions of the different types of adjustments that can be made when calculating EBITDA. 

• Discretionary Expenses: Expenses paid for by your business that are a personal benefit to you are discretionary. To qualify, the expense must personally benefit you and not your business or your employees. These expenses must be paid for by your business and be documented as an expense on your profit and loss statements. 
• Extraordinary Expenses: Expenses your business paid for that are exceptional, unlikely to recur, and are documented as extraordinary are known as extraordinary expenses. Examples include expenses associated with natural disasters, relocation of your business, or a lawsuit. Examples that don’t qualify include a marketing campaign that failed or headhunter fees to replace a manager who resigned.
• Non-Operating Revenue and Expenses: These are expenses or revenue unrelated to your core business operations. Examples of non-operating revenue include interest earned on investments, revenue from the sale of a large asset such as the sale of equipment that’s no longer used in your business, or an insurance settlement. Examples of non-operating expenses include interest payments on debt and payments to settle lawsuits.

Sample Adjustments

The following adjustments are generally allowable and can be adjusted when calculating EBITDA:

• Accounting: Any accounting fees incurred that are unrelated to your business or are for personal matters
• Amortization: All amortization (the ‘A’ in EBITDA)
• Barter Fees: Any barter-related fees, expenses, and income 
• Cost of Goods: Expenses for anything purchased for personal use that wasn’t used for your business
• Depreciation: All depreciation (the ‘D’ in EBITDA)
• Entertainment: All personal entertainment and related expenses
• Interest: All interest expenses (the ‘I’ in EBITDA)
• Legal: Any personal legal fees
• Meals: Any personal meal expenses
• Medical: Any personal medical expenses
• One-Time Expenses: Any capital investments in new equipment, one-time start-up expenses for new product lines, build-outs, major repairs, or one-time legal fees
• Payroll: Any salaries for non-working family members
• Personal Vehicles: Any automotive expenses, payments, fuel, insurance, and repairs for personal use
• Repairs: Any repairs for your personal home or other personal property
• Supplies: Personal groceries and other supplies
• Taxes: All corporate income taxes (the ‘T’ in EBITDA)
• Telephone: Personal cell phone expenses
• Travel: Any expenses related to personal or nonessential travel.

The following expenses can be partially adjusted:

• Charitable Contributions: Owners often make charitable contributions with the expectation of receiving business in return. For example, an owner of a company might sponsor a local sports team and hand out free products at events or make cash contributions. Doing so is often expected to generate publicity and exposure for the business, but directly measuring the results is difficult. You can adjust any personal contributions made that aren’t related to your business or in which your business didn’t receive any exposure, such as a private donation to your church, but you should leave in any charitable contributions that were expected to benefit your business.
• Continuing Education: Some educational expenses are considered discretionary and shouldn’t be removed just because they were optional. These expenses should be removed only if they were personal in nature and weren’t related to the business. For example, if continuing education is the norm in your business or if it’s directly related to your business, leave it in.
• Dues and Subscriptions: Any personal fees such as country club dues that had no expectation of benefitting your business can be removed. All business-related dues should be left in.
• Retirement Contributions: You can remove your 401(k) and IRA contributions for yourself and any family members, but don’t remove any fees related to retirement plans that benefit your employees.

The following expenses should be normalized to market rates:

• Bad Debt: You should ideally establish a reserve for bad debt, or an allowance for doubtful accounts. If you don’t, adjust any bad debt that’s excessive based on your prior years. You can normalize this, but you shouldn’t remove it completely. If you had bad debt in the past in your business, you’re likely to have it again. This should be normalized based on your prior years by deducting an even amount each year (i.e., establishing a reserve for bad debt), or by spreading a large bad debt expense over several years.
• Personal Insurance: Any personal insurance expenses such as health insurance, dental insurance, and life insurance, should be adjusted to what might be considered reasonable for a president of a company of your size. Most buyers in the middle market will hire someone to continue running the company, and personal insurance expenses are often included in the compensation package.
• Rent: If you own the property and lease it back to your business, the rent should be normalized to current market rental rates based on the cost to rent the property in the open market, not based on your cost of ownership.
• Underpaid Employees: Salaries for underpaid employees, such as family members working in your business, should be normalized to market value.
• Unpaid Family Members: Salaries for working family members should be adjusted based on the actual cost in the marketplace. Salaries for non-working family members should be added back.
• Your Salary: Your salary should be normalized to market rates. For most middle-market business owners, this equates to a salary of $200,000 to $500,000 per year, plus benefits.

The following expenses shouldn’t be removed and can’t be adjusted. You can identify these as expenses that can be reduced or limited, but they shouldn’t be adjusted when calculating EBITDA:

• Advertising: Owners often attempt to remove fees related to advertising because the advertising campaign wasn’t effective and didn’t bring in any business. But developing successful advertising campaigns always involves risk. This is a routine business expense and can’t be removed just because the campaign was unsuccessful. A new owner must continue to advertise and market the business, and many campaigns are unsuccessful.
• Entertainment and Meals: Dining with clients is critical to building relationships. These expenses shouldn’t be removed just because they were optional.
• Membership: Membership fees in country clubs and other clubs that are optional should be identified but not adjusted. 

Tips for Making Adjustments

Making adjustments is an integral part of the valuation process. Properly adjusted financials allow for the accurate comparison of different businesses. When making adjustments, it’s important to remember that buyers will examine them and may raise questions if any adjustments appear to be inaccurate, or the buyer may simply walk away without discussing their concerns. Here are several tips to ensure the adjustments you make will be accepted by buyers.

Be Thorough

All adjustments should be concise and verifiable. The more thorough and accurate the documentation is regarding your expenses, the better. If you’re aggressive or inaccurate with one adjustment, most buyers will question the credibility of everything else you say from that point on. The more detail you provide and the more documentation there is to back up your adjustments, the more likely you’ll sell your business quickly and for the best price possible. That’s why I recommend hiring a third party to review your adjustments and assist you in calculating your EBITDA. 

If you’re aggressive or inaccurate with one adjustment, most buyers will question the credibility of everything else you say from that point on.

Be Conservative

When making adjustments, buyers will have the opportunity to review the backup documentation for the adjustments you made to your financial statements during the due diligence period. If you’re aggressive in the adjustments you make, it’s possible the buyer won’t accept all of them. On the other hand, if you’re conservative in the adjustments you make, it’s less likely the buyer will dispute the legitimacy of any of them. Some adjustments are in gray areas – for example, you may have adjusted out $10,000 in country club dues. But a buyer may reason that you have golfed with a few clients before and may not necessarily have landed or retained these clients if you didn’t give them the opportunity to beat you on that last dog-leg par four.

While buyers may not necessarily voice the fact that they aren’t accepting your adjustments, any aggressive adjustments you make can cause more concern than necessary and as a result, they may begin to question other areas of your business more stringently. 

While the buyer won’t necessarily approve or reject every adjustment you make, if more than a few are questionable, the buyer is likely to downgrade their valuation if you overestimate EBITDA.

When selling a business, always be conservative when making adjustments to your financials. If you’re conservative, the buyer will assume you’ve been conservative regarding other issues as well, and the buyer may feel the need to verify fewer of your representations during due diligence. On the other hand, if your adjustments are aggressive, the buyer may feel the need to perform more thorough due diligence.

Value is a function of risk. The lower the risk, the higher the value. A buyer who’s dealing with a conservative seller will view the transaction as less risky and may be willing to pay a higher multiple than if the buyer were dealing with an aggressive seller who may represent more risk. Keep in mind that when I say “aggressive” in the context of selling a business, I’m referring to the representations you’re making. 

An example of an aggressive representation is, “I can definitely grow revenue by 20% per year for the next five years.” 

An example of a conservative representation would be, “I have grown revenue by 18% to 22% during the previous three consecutive years, and I hope this trend will continue. But I’m always aware that the economic and competitive landscape can change at a moment’s notice, and my estimates are just that – estimates.”

If your stance is aggressive, the buyer may also propose much more thorough reps and warranties in the purchase agreement to protect themselves after the closing. This could include language in which you warrant that any claims you made were true to the best of your knowledge. If your representations later prove to be untrue, your representations will come back to bite you, even after the closing. The buyer can sue you or even offset losses from your representations against future payments via a setoff against any future payments, such as a promissory note or earnout. If you want to sleep soundly at night after you sell your business, make conservative statements.

Value is a function of risk. The lower the risk, the higher the value. 

Minimize Adjustments

The fewer adjustments there are, the cleaner your financials will look when selling your business. Look at your profit and loss statement. How many total adjustments do you have? Don’t focus on the total in dollars (for example, $936,950 in adjustments) but instead look at the total number of adjustments (as in, 14 adjustments in the most recent year). Remember – the fewer adjustments, the better. 

When a buyer first looks at your profit and loss statement, they’ll immediately notice the total number of adjustments you make. If your adjusted profit and loss statement is clean, with minimal adjustments, the buyer will assume that due diligence will be faster, less expensive and that this transaction will represent less risk for them. On the other hand, if your financial statements include dozens of adjustments and there are other inconsistencies they notice at the outset, many buyers will walk away at this point because they won’t want to invest the time and effort in trying to unravel the situation.

Don’t include any small adjustments that don’t meaningfully impact EBITDA. It’s generally a good idea to avoid making any single adjustment less than $5,000 to $10,000, although the amount depends on the size of your business. Your goal should be to reduce the total number of individual adjustments, not the total amount of adjustments. Small adjustments don’t impact EBITDA enough to impact the valuation substantially, and generally aren’t worth making. A financial statement with fewer adjustments looks “cleaner” to a buyer and may justify a higher valuation because the buyer may perceive that fewer adjustments must be verified during due diligence.

If you minimize adjustments, buyers will assume you’ll be easier to deal with than other business owners and that you’re running your business in an upright, above-board fashion. Collectively, these strategies build trust, which reduces risk for the buyer and maximizes value for you. It may even lessen the burden of due diligence. The ideal scenario is to eliminate adjustments altogether at least two to three years prior to a sale. This will increase the value of your business and reduce the burden of due diligence. 

Always be conservative when making adjustments to your financials.

Impact of Adjustments on Valuation

If you want to maximize the purchase price, there’s one simple trick you can employ. Be conservative regarding your adjustments, but be aggressive regarding the multiple you choose when valuing your business. 

Here’s an example:

Impact of Conservative vs. Aggressive Adjustments
	Business A	Business B
Net Income	$5,000,000	$5,000,000
Adjustments	$1,000,000	$500,000
EBITDA (Net Income + Adjustments)	$6,000,000	$5,500,000
Multiple	5.0	5.5
Asking Price (EBITDA x Multiple)	$30,000,000	$30,250,000

You can often justify this higher multiple in Business B if you can demonstrate to the buyer that your business represents less risk. The strategies above don’t prevent you from keeping “potential adjustments” in your back pocket – just don’t show them to the buyer until you need to. If the buyer is performing due diligence and uncovers a few problem areas, they may attempt to renegotiate the purchase price. This is the perfect time to sit down and have a talk with the buyer. Walk them through the expenses you decided not to adjust. Tell the buyer you wanted to be as conservative as possible and point out each expense you didn’t make but could have. By doing so, you’re offsetting a potential renegotiation of the purchase price and reassuring the buyer that you’ve been conservative in the representations you’ve made.

If you want to maximize the purchase price, be conservative regarding your adjustments, but be aggressive regarding the multiple.

How to Easily Produce a Detailed List of Adjustments

The best way to prepare a list of your adjustments is to export a “general ledger” from your accounting software to Microsoft Excel or a similar program. Once exported, mark each adjustment with an “X” or highlight the entire row. By doing this, you’ll have a spreadsheet that clearly identifies all your adjustments that you can give to the buyer when they perform due diligence. Simply show buyers this report, and the buyer will be able to tie each adjustment to the specific entries in your accounting software. Remember that the buyer may request the source documents, such as receipts for the transactions, so also be prepared to produce detailed invoices or receipts if necessary.