The overwhelming valuation standard for private companies is a multiple of annual cash flow. The most common definition of cash flow in M&A transactions is EBITDA, which is Earnings Before Interest, Taxes, Depreciation, and Amortization.
The calculation of EBITDA is produced through a standard accounting exercise familiar to all accountants, and most controllers and bookkeepers. The EBITDA is generally what was produced in the prior fiscal year, but variations include trailing 12 months (which produces a higher EBITDA for companies growing in profitability) and current year (which therefore includes projections for the remainder of the current year and produces, for companies growing in profitability, a higher EBITDA).
Example: Let’s assume the Seller most recently earned $1 million in EBITDA and is growing at 20% annually. If the appropriate (and we’ll discuss “appropriate” below) EBITDA multiple for the Seller’s business were 6X the most recent year, the business would be worth $6MM (i.e., 6 times EBITDA of $1MM). Let’s say the Seller had business debt of $1MM. After paying off debt of $1MM, and assuming no other adjustments (e.g., holdbacks, earnouts), Seller would receive $5MM in the sale. If the appropriate multiple were 6X applied to projected current year EBIDA of $1.2MM, the business would be worth $7.2MM, and Seller would receive $6.2MM in the sale. If the appropriate multiple were 6X applied to next year’s projected EBITDA of $1.44MM, Seller would receive $7.64MM in the sale (i.e., 6 times EBITDA of $1.44MM, less the $1MM in debt).
The complications in calculating the appropriate EBITDA in an M&A transaction arise where something abnormal or extraordinary occurred that pushed the EBITDA lower or higher from what it would be under normal circumstances. The following are examples of common extraordinary items affecting EBITDA:
Owner Compensation. Under or over market compensation paid to the business owners. Let’s say the Seller paid herself $500,000 annually, where the market rate for an executive like her is $200,000. Seller will want to add the amount paid over market, or $300,000, to her EBITDA.
Extraordinary Expenses. For example, uninsured repairs for damage resulting from a 100-year flood or a complete branding overhaul that would not occur under normal circumstances. The Seller will want to reduce his/her/their expenses, thereby increasing EBITDA, by those amounts.
Owner Expenses. Expenses arguably relating to the Seller’s personal life that would not ordinarily be a business expense. Again, Seller will want to reduce his/her/their expenses, thereby increasing EBITDA, by those amounts.
Extraordinary Income. For example, a disaster relief grant or payment of a large old account receivable that had been written of years ago that would not occur under normal circumstances. Buyer will want to reduce EBITDA by those amounts.
EBITDA adjustments usually become fodder for negotiation between Seller and the Buyer. Seller argues that a number of expenses were extraordinary and should not be expected by the Buyer under ordinary circumstances, and Seller therefore adjusts their EBITDA upward. The Buyer argues that such expenses are really quite ordinary in nature and therefore is quite happy with the lower, unadjusted EBITDA.
When we advise sellers in calculating a normalized, or adjusted, EBITDA, we recommend calculating a worst-case scenario (i.e., no expense reductions and all possible revenue deductions), a best-case scenario (all arguable expense reductions and no revenue reductions), and what you expect would be a reasonable negotiated compromise of items in each of the other scenarios. As with all negotiations, your first position will be the best-case scenario, but you will be prepared for that to be adjusted downward through negotiation.
Check future posts for a discussion of what multiple is applied to this cash flow.
There is some science here, and a great deal of art. We have honed our capabilities in valuation – day-by-day – over the course of our careers.
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David Traversi, Partner, Newport (firstname.lastname@example.org)