Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) is often used as a basis for determining the value of privately held companies. It allows a company’s value to be estimated based on other transactions that have taken place with similar size and characteristics.
Using EBITDA allows for an analysis of the profitability of a company regardless of the capital structure or the tax strategies employed. In order for EBITDA comparisons to be useful, however, adjustments need to be made so the resulting number is representative of the true earnings capacity of the business, which allows for an apples-to-apples comparison.
This process uses the past to help predict the future, so the key is to examine and account for income and expenses that a new owner can reasonably expect to not encounter regularly moving forward. To reach the true value of the business, you must weed out unusual or non-recurring events that create a skewed value. The Houston Chronicle uses the following example to explain recasting:
Your business might own a single parcel of land. If you sold that land, the gain from the sale would go on your income statement and would increase your profit for the year. But the land sale would be a one-time event—an aberration. You won't be selling more land in the years to come, so that gain isn't repeatable, and your profit for the year is abnormally high. On a normalized income statement, you would remove the land sale, along with all other one-time, unusual or nonrecurring items. The only items that would remain on the statement would be the revenues and expenses directly related to the normal operations of your business.
Recasting is exceedingly important to determine a realistic value when selling your business and to make sure you’re not severely undervaluing or overvaluing your biggest asset. Be sure to keep clear records so a potential buyer can see exactly what you recast and why.
Typical recasting adjustments to arrive at an adjusted EBITDA include:
Adjustment to Market Rates
- Owner salaries and bonuses
- Rent (if real estate is owned—in other words, if you own the real estate the company is occupying and do not pay market rent, you must account for the rent that the new business owner will pay)
These are one-time or unusual operating expenses generally not expected to recur in the future, such as:
- Legal, accounting or other professional fees for lawsuits, audits, special projects or similar events
- Moving expenses if the company relocated or expanded (estimates are okay since these may be hard to track)
- Major upgrades to computer systems or similar that could have been capitalized
- Repairs due to major disasters, such as fire, flood, etc.
Discretionary Expenses / Owner Perks
These must have nothing to do with the business and should be large enough that they don’t get lost in the rounding. They can include:
- Owner health or life insurance
- Owner retirement contributions
- Personal vehicle expenses
- Charitable contributions
- Personal trips or entertainment expenses
- Salary payments to family members who are not involved in the business
Bonuses, retirement plans and other benefits for employees are not discretionary. If employees receive these on a regular basis, they consider them part of their compensation and taking them away will be viewed as a pay cut.
Once you’ve made these adjustments, the end result should be an adjusted EBITDA that is an indicator of the future profitability of the company.
What will it take to transition your business smoothly?