Why Your Business is NOT Valued on a Multiple of EBITDA

One of the most misunderstood principles about how companies are valued is the role that EBITDA plays in the process. If you have heard that your company will sell for a multiple of EBITDA, that's only partially correct and using that as a metric can significantly distort things.

This blog aims to share insights on what adjustments to EBITDA are necessary to ensure your company is properly valued.

What is EBITDA?

EBITDA is defined as Earnings Before Interest, Taxes, Depreciation, and Amortization. By including interest payments, taxes, depreciation, and amortization as part of the earnings calculation, EBITDA represents the cash profit generated by the company's operations.

If EBITDA is Not the Basis for a Company's Value, What is?

There are actually quite a few methods used for valuing a company. However, if the purpose of a valuation is to understand the company's value in preparation for selling it, using a market-based approach in which the recent sale of comparable businesses is used is by far the most common and accurate one.

For smaller businesses (less than $5 million in revenue) where the likely buyer is an individual who intends to own and operate the company after the sale, a multiple of SDE or Seller's Discretionary Earnings is used.

For larger companies where the likely buyer is a strategic one or a private equity group, a multiple of Adjusted EBITDA is used. Keep in mind that when someone says, "Your company is worth some multiple of EBITDA," it is actually Adjusted EBITDA they are referring to. And the difference between the two can have a profound impact on your company's value.

What's the Difference Between EBITDA and Adjusted EBITDA?

As the name suggests, Adjusted EBITDA makes adjustments to EBITDA. By adjusting EBITDA, potential buyers are able to see the true earning power of the company. It does so by removing, from EBITDA, owner compensation and discretionary benefits and various one-time or non-recurring expenses or income such as:

• Facility relocation or renovation expenses
• Rent that is above or below fair market value
• One-time technology upgrade
• Legal fees for a one-time event
• Certain related party transactions
• Costs related to the sale of the company
• Non-operating income

As importantly, it also adjusts EBITDA to reflect the fair market compensation required to either replace the former owner or retain their services going forward. This is often overlooked, and it typically has a substantial impact on the Adjusted EBITDA figure.

Why Can't I Value My Company on Multiple Revenues?

We've spoken to numerous business owners over the years who have said they know of someone who sold their company for some multiple or percentage of its revenue. There are certainly some industries (typically service-related ones) whose revenue is recurring and is essentially guaranteed well into the future, and they can be valued on a multiple of revenue. But this is the exception, not the rule.

What is more common is that different industries have their own "benchmark" as to what a company in that industry, on average, sells for as a multiple or percent of revenues. These benchmarks are used for reference only, and the final sale price of the company may be substantially higher or lower than that benchmark depending on the company's Adjusted EBITDA. Here's an example.

Let's say that for a given industry, the percentage of revenue metric is 50%, and the Adjusted EBITDA multiple is 5.

• Company A has revenues of $30 million and an Adjusted EBITDA of $2 million. If it sells for $10 million, that equates to a 5-time multiple of Adjusted EBITDA and 33.3% of revenues.
• Company B has revenues of $30 million and an Adjusted EBITDA of $4 million. If it sells for $20 million, that equates to a 5-time multiple of Adjusted EBITDA and 66.7% of revenues.
• Neither company sold at the percent of revenues industry average. Company A sold for far less than that, and Company B sold for far more due to the Adjusted EBITDA number.

While a multiple or percent of revenues benchmark can be useful as a point of reference, Adjusted EBITDA is the metric buyers will use to determine the final selling price.

What Multiple of Adjusted EBITDA Will My Company Sell For?

There are many factors that impact what multiple will be used including:

• Industry norms (different industries have different multiples)
• Size of the company (larger companies sell for higher multiples)
• How does your company compare to similar-sized companies in your industry?
• Growth potential (companies that have a clear growth path sell for higher multiples)
• Market conditions (higher buyer demand leads to higher multiples)

Numerous other objective and subjective factors are considered when determining the probable multiple used in valuing your company. An experienced mergers and acquisition advisory firm can assist you with this.

What Else Should I Know If I Am Contemplating the Sale of My Company?

In talking to business owners over the last year, we believe the most critical item that gets glossed over is the financial impact of the sale to the owner. Knowing how much your company will likely sell for is not enough. You need to know how much of the sale price you get to keep at the end of the day after taxes, fees, and transaction costs are considered.

At True North Mergers & Acquisitions, we have created a proprietary valuation system called the Compass Exit OpinionT™ that will give you a realistic estimate of what your company is worth and help you determine if selling it will meet your financial goals.

Learn more about the value of your company by connecting with Randy Krivo, Managing Director at True North Mergers & Acquisitions.