August 20, 2019 – Aaron Solganick, CEO – Solganick & Co.
As investment bankers who sell companies often, we notice that buyers and investors in software and technology companies tend to use either a multiple of revenues or a multiple of EBITDA, or adjusted EBITDA, to formulate their valuation a majority of the time.
What is EBITDA?
Earnings before interest, taxes, depreciation and amortization, or EBITDA, is a measure of a company’s operating efficiency. EBITDA is a way to measure profits without having to consider other factors such as financing costs (interest), accounting practices (depreciation and amortization) and taxes.
Calculating EBITDA is usually a fairly simple process and, in most cases, requires only the information on a company’s income statement and/or cash flow statement.
Where the fun comes in is calculating Adjusted EBITDA, which can be accepted, or not, in valuing software and technology companies.
So, what is Adjusted EBITDA?
This is where the art blends in with the science! To start, adjustments, or “add backs,” tend to seek out non-cash accounting adjustments, one-time expense items, excess compensation compared to market (for salaries, etc.), rent paid to the owner that is lower than current market rates, one time legal expenses, bad debt expense, and several other expenses that are not necessary to run the operations of the business.
There are many reasons to use Adjusted EBITDA; some are good, and some are not. Adjustments usually take place when a business is being valued for mergers and acquisitions (M&A) that are taking place, or when actual results are being compared to forecast/budget/guidance/expectations.
Adjustments include items that are truly non-recurring and don’t reflect current or future operations of the business. It makes sense to “add back” these items as accounting methods will not smooth them out over time, and can result in a significant earnings volatility.
Here are the top EBITDA Adjustments, according to the Corporate Finance Institute and our M&A professionals:
Non-Arms-Length Revenue or Expenses
This refers to a company that enters into transactions with related parties at a price that is lower or higher than market rates. An example would be if your operating company buys supplies from another company owned by a major shareholder at prices higher than market value. When your operating company goes up for sale, you would normalize EBITDA to reflect the fair market value of these supplies.
Revenue or Expenses Generated by Redundant Assets
Redundant assets are not used to run the business. Imagine that your business owns a home on the beach that is occasionally used for company functions or as an incentive for good performance among your employees. The beach home isn’t really needed to run the business— it would be redundant to a buyer. Therefore, if the expenses related to this home have been paid for by the company, these expenses would be added back to normalize EBITDA.
Excess Owner Salaries and Bonuses
Owner salaries are often higher or lower than the regular salary that would be paid to a third-party manager. Also, when owners manage the business, a bonus may be declared at the end of the year to reduce income taxes. This bonus and any extraordinary owner salaries need to be added back to calculate recurring EBITDA. An estimate of the third-party manager compensation would be deducted. The typical result, particularly if large year-end owner bonuses have been paid, is an increase in EBITDA.
Rent of Facilities at Prices Above or Below Fair Market Value
Many companies do not own the facilities they occupy, but instead rent them from a holding company owned by a shareholder. This is similar to related party transactions that need to be adjusted, but I single it out as a separate point given how frequently it occurs. The rent is often arbitrarily set above the going market rent. EBITDA would be adjusted upwards by adding back the arbitrary, non-arms-length rent and subtracting the true market rent.
If a new business line has been launched during the period when the historical results are being analyzed, the associated start-up costs should be added back to EBITDA. This is because the costs are sunk and will not be incurred going forward.
Lawsuits, Arbitrations, Insurance Claim Recoveries and One-Time Disputes
Any extraordinary income or expenses that may have been settled during the review period would not recur. Therefore, they would be deducted (in the case of income such as an insurance claim recovery) or added back (in the case of an expense such as a lawsuit settlement).
One Time Professional Fees
Look out for expenses incurred that relate to matters that do not recur in the future. An example is legal fees a business may incur in settling a legal dispute. Not only would you add the settlement expense back to EBITDA, but you would also add back the related legal expenses. The same applies for accounting fees on special transactions or marketing costs if you did a one-time marketing campaign.
Repairs and Maintenance
One of the most overlooked categories to review is repairs and maintenance. Often, private business owners will aggressively categorize capital expenses as repairs in order to minimize taxes. While this practice may reduce annual taxes, it will hurt the valuation when the business is sold by reducing historical EBITDA. Therefore, an adequate review to separate and add any of these capital items back to EBITDA is a must.
Other Income and Expenses
This financial statement category is usually loaded with items that may be added back to EBITDA. It is also sometimes the dumping ground for expenses that cannot be coded elsewhere. Pay careful attention to these accounts, and make sure that anything that is not recurring gets added back. For example, some companies record one-time employee bonuses or special donation expenses in this category. These should definitely be added back to EBITDA.
And, don’t forget to figure out the impact of ASC 606. What’s ASC 606?
ASC 606 is a new, mandatory accounting standard for revenue recognition under U.S. GAAP that will impact many industries, with a particularly significant effect on the software sector as it replaces existing guidance that is particularly relevant to the software sector. US GAAP and IFRS changes are expected to synchronize international and US standards.
ASC 606 is a revenue recognition standard that will impact the software industry, particularly companies that offer on-premise subscription licenses over a finite, multi-year period. In short, revenues related to these contracts were previously recognized ratably over the length of the contract but now may be accelerated under ASC 606. This new standard is unlikely to have a material impact on how affected software companies operate and conduct business, but it will lead to quarterly fluctuations in revenue and, subsequently, earnings due to the concentrated nature of the enterprise software sales cycle. This has implications on valuation methods for software companies.
The impact of ASC 606 is essentially a matter of timing for when revenue hits the income statement, but cash flow is largely unchanged because contract payment terms will remain the same. There may be some impact to quarterly cash flow given the potential for acceleration of tax payments (GAAP financials are the point of departure for computing taxes) and administrative costs associated with implementing ASC 606.
Overall, please use a good accounting team, CFO, investment bank, financial advisor, etc. to figure out potential adjustments that can impact and potentially improve your valuation when selling your business.
Solganick & Co. is a software and technology focused investment banking firm that can assist with these efforts. For more information, contact an M&A professional at email@example.com