Add-Backs To EBITDA Can Substantially Increase Business Valuations

CHARLES FAY, SENIOR M&A ADVISOR BMI MERGERS & ACQUISITIONS

EBITDA is an abbreviation for “earnings before interest, taxes, depreciation, and amortization.” It is calculated by taking operating income and adding back to it, interest, depreciation, and amortization expenses. EBITDA is a key metric widely used by financial and investment professionals operating in the lower-middle market to analyze a company’s operating profitability and estimate valuations. The first step in estimating a market-based valuation is to calculate adjusted EBITDA. This metric is used to “normalize” income and expenses based on what a new buyer should expect. The recommended approach to calculating adjusted EBITDA starts with operating income and then adds back interest, depreciation, and amortization. Additional add-backs to operating expenses should then be accounted for. The adjusted EBITDA for each year should then be totaled, and a multi-year average calculated.

Common Addbacks to EBITDA:

Owner Compensation: Many closely held private companies’ owners compensate themselves with generous salaries, bonuses, and benefits. While nothing is wrong with this approach, an acquirer is unlikely to pay that level of compensation to the new executive. Therefore, the add-back is the difference between the expected go-forward amount and the current amount. Note that the go-forward salary for such a position should be “at arms-length” (no ownership) and represent the amount that would be paid for “like services by like organizations in like circumstances.” For example, an owner paid himself a salary of $500,000. If the industry benchmark for such a position is $200,000, $300,000 would be the add-back. But conversely, if that same owner was paid just $100,000, there would be a negative add-back of $100,000. Owner Payroll Taxes and Benefits: In addition to adjusting executive salary, be sure to account for the corresponding change in taxes and benefits. These add-backs can be significant. In the previous example, with a $300,000 salary add-back, there may also be a payroll tax and benefit add-back totaling $45,500. This includes a payroll tax add-back of perhaps $24,000 (8% of salary add-back), a health insurance add-back of $15,000 (5% of salary add-back) and perhaps a 401K max contribution add-back of $6,500 (reduction from $26,000 to $19,500).

Rent: Many closely held private companies’ owners separately own the building and charge the business monthly rent. The monthly charge for rent can be significantly above or below the local market price for similar real estate. Buyers will want to pay FMV (Fair Market Value), and sellers are advised to research the local market for competitive pricing and include a positive or negative add-back based on the difference between the go-forward annual rent and the current rent. As an example, let’s assume the seller is charging the business $3/SF below market. A $20,000 SF facility would then have a negative $60,000 add-back. Personal Expenses: Running personal expenses through the company is common in closely held companies. Any personal expenses such as those listed below should be identified and subject to an add-back.

• Country club, or other club dues and/or fees • Owner automobile expenses (monthly payment, insurance, gas, etc.) • Family members on the payroll that are not working in the business • Travel, meals, entertainment for personal use, not business-related • Any other expense that is personal in nature and not a businessrelated expense Charitable Donations: Business owners are frequently active community members and sometimes make philanthropic contributions to nonprofit organizations. If a new owner could forgo these gifts without impacting the business, they can be listed as add-backs to impact EBITDA positively.