A key point in any merger or acquisition transaction, whether buying or selling a business or investing in one or seeking investment in one is arriving at a value. In M&A transactions one of the main ways of arriving at value is based on the EBITDA of the business. From there value can be derived from multiples of EBITDA by reference to the sector the business is in.
So, what is EBITDA and why is it treated with such importance in valuation? In this article we explore both points.
What does EBITDA mean?
“Earnings Before Interest, Taxes, Depreciation and Amortisation”. That’s what the acronym stands for. It’s not automatically apparent from statutory accounts where you typically see operating profit. However, with a bit more work you can get to the EBITDA number by adding back depreciation (this may be carried generally in the accounts), interest and amortisation.
Why is EBITDA so important?
For buyers and investors the EBITDA of a business is important as it shows how much free cash can be generated before the business on a sustainable basis before it needs to make investments. To that extent it is an objective base line and has become the default method of arriving at value ahead of other measures such as those based on revenue or cashflow.
For any business looking to sell or attract investment it is therefore worth doing the EBITDA calculation to see the business through the eyes of a prospective buyer or investor. Once EBITDA is calculated it is worth checking to see it should be adjusted, with transparency, to reflect the circumstances of the proposed transaction i.e., is the EBITDA of the business going to be as reflective of the business after acquisition or investment as it was before or does it need to be “adjusted” to reflect the post-acquisition or investment scenario.
For a business owner used to judging their business by reference to operating profit value by way of EBITDA and particularly adjusted EBITDA can come as something of a surprise. Take for example business owner remuneration which exists prior to acquisition or investment but may change afterwards as they leave the business or their remuneration is put on a more formal basis. For example, a business owner may have taken excess remuneration because they can or they may have split remuneration between salary and dividends. Both are perfectly normal but will not be reflective of EBITDA going forward and so it is fair to arrive at an adjusted EBITDA figure to reflect that. Typically, these adjustments relate to the difference between the flexibility of being an owner managed business and one which is run on more ‘corporate’ lines. Other examples we see involve paying above or below market rate for property owned by the business owner or a connected person or ‘soft’ prices charged by connected person suppliers.
Applying EBITDA Multiples
Having arrived at a number for EBITDA (adjusted or not) then a buyer, seller or investor will want to look at how to multiply that number to arrive at valuation. The global average is probably around 4 or 5 but like all averages that tells only half the story. Some multiples will be much higher and some much lower and different sectors have their own averages. Also, there is the problem that averages generally and within sectors tend to reflect public or reported transactions whereas most transactions fall outside those parameters.
A corporate finance advisor will probably have the latest trends to hand and organisations like Dealsuite do track them. Essentially businesses that can roll out nationally and internationally with relative ease tend to attract higher multiples; technology-based businesses for example or those in life sciences.
Remember also that despite the science of EBITDA some multiples may be driven up through competition between buyers or investors or because the transaction has a strategic element making it more attractive or driven down because the business has not presented or prepared itself well. This latter point is something that business owners do not always pay close attention to relying instead on the numbers to speak for themselves.
For buyers, sellers, investors and those seeking investment seeing the business through the lens of EBITDA is crucial. It is how the world tends to see and arrive at value.
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