Although EBITDA is a common term in the M&A community, it is not a familiar term for many other business folks. This column will attempt to shed some light on how an EBITDA is calculated and why it is so central to the selling and buying process.
The EBITDA provides a mechanism for prospective buyers to identify the cash flow that will be available to them post-closing. Of particular significance in the calculation are add-backs, which are commonly misunderstood.
Add-backs are various forms of compensation an owner may draw from a business that will disappear under new ownership. For example, if the market rate for a president or CEO or general manager of a harness business is $100,000, and an owner is paying himself $400,000 to perform any of these functions, the add-back is $300,000. (Normally, if a seller is staying on for a time to perform any of these roles, the seller will stay post-closing at a market rate.)
Add-backs range from being immaterial to composing the majority of the EBITDA calculation. Often, if an owner has been in place for a long time, accounting for everything he or she is taking out of the business can be quite a complicated process, but it is critical to arrive at an accurate figure so the owner can receive full value for the sale. (Depreciation and amortization are the other EBITDA items that are added to a net pre-tax profit.)
Harness companies may have many positive attributes that owners believe should have a bearing on valuation, but the starting point is always the EBITDA. Once this number has been determined, the range of valuation multiples becomes a function of other attributes such as company size, customer concentration, and future potential.
Although there is a direct correlation between size and multiple (bigger is better), customer concentration is not as simple a calculation. It may not reduce a multiple, but it can narrow the number of potential buyers due to a misguided belief that concentration is always a negative.
Another particularly important factor is potential. When it can be demonstrated that a harness company is likely to increase its share of the market it is serving, that will boost the multiple.
Once a harness owner decides to sell, the very first step should be calculating EBITDA––and then estimating the range of multiples (min/max) to determine value. While it is always my job to get the max end of this range––and my contacts and process often enable me to do so––there are no guarantees. The fact that the market determines value is what sellers need to realize before starting down this road.