The following is adapted from The Exit-Strategy Playbook.
After you pour your heart and soul into building your business, you deserve to get maximum value out of it when you finally decide it’s time to sell. But if you haven’t exited a business before, it’s not always clear how to do that. Where do you start? And how can you present your business in the best possible light, so potential buyers are willing to offer you top dollar for it?
While there are many steps involved in a successful business sale, one of the most important is getting clarity around your EBITDA (earnings before interest, taxes, depreciation, and amortization). That’s because prospective buyers want a clear understanding of your company’s financial picture, and EBITDA is a key component of that.
Cash profits can vary wildly among businesses in the same industry, and as a result, they often don’t provide a clear picture with respect to the health or true value of a business. So, in order to normalize valuation, buyers focus on EBITDA.
This number serves to level the valuation playing field when compared to other companies in the same industry. Ultimately, it is a measure by which all companies are valued by most strategic and financial buyers—and as such, is a critical number for you to understand and be aware of.
If you haven’t heard of EBITDA before, or aren’t sure how it relates to your business, it’s time to get clarity around what it means and how it applies to you. Don’t worry: while it may seem complicated, by breaking it down (which I’ll do for you here), you’ll soon get the hang of it.
As-Reported and Adjusted EBITDA
There are different types of EBITDA. For example, as-reported EBITDA, or definitional EBITDA, is based solely on what happened for the financial period (month, quarter, year) as reported by the numbers submitted on your financial statements. In essence, it only considers the literal definitional adjustments to net income to derive at EBITDA. You might say that reported EBITDA is simply “whatever it is.”
As-reported EBITDA is frequently adjusted when providing financial statements to prospective buyers or lenders. These adjustments are added back to the reported EBITDA to create your adjusted EBITDA. Several types of adjustments can be made, including adjustments for extraordinary expenses, normalizing adjustments, and out-of-period adjustments.
Extraordinary expenses are one-time expenses that won’t reoccur in the future. Perhaps you restructured a department and had layoffs. Because you’re a generous person, you paid a large severance to the employees who were displaced. Those severance expenses impacted your EBITDA for a given time period, but you wouldn’t have those expenses the next year. As a result, you would seek to get credit for those expenses from a buyer by adding them back to earnings.
An example of normalizing adjustments would be layering in rent expense if the company doesn’t pay rent today. For example, maybe the owner owns the building and doesn’t charge the company rent, but the buyer of the business isn’t buying the building and will now need to start paying market rent.
Out-of-period adjustments are made when income or expenses were recorded in the incorrect month or year and need to be moved to the appropriate period. An example of this would be a bonus expense that is recorded all at year-end (or even after year-end) but should be expensed throughout the year (or moved to the appropriate year).
Pro Forma Adjusted EBITDA
Pro forma adjusted EBITDA, sometimes called run rate EBITDA, builds on adjusted EBITDA. Essentially, it takes the adjustments and adds another layer of projections on top. Sometimes there are seller pro forma adjustments (changes the seller has made or anticipates making), and sometimes there are buyer pro forma adjustments (changes the buyer is planning to make).
During the course of the year, things happen. Perhaps you signed three big new accounts, one three months into the year, another six months into the year, and the last one 11 months into the year.
In your as-reported EBITDA for that period, there are only nine months of revenue from the first contract, six months from the second, and one month from the third. In the next year, there will be 12 months of revenue from all three of those contracts, so your business could state a pro forma EBITDA where you project forward the revenue impact of that new business over the next 12 months.
Anytime you pro forma positive gains, you need to pro forma losses too. Maybe you lost a contract eight months into the year. Next year, you will have no revenue from that customer, so you’ll need to remove those eight months going forward in a pro forma calculation. The more accurate you are when making these adjustments, the faster you’ll get through a sale process. Your buyer will do the work to catch one-sided adjustments, so save yourself both time by being accurate.
Other Types of EBITDA
There are many other related EBITDA terms, including trailing twelve months (TTM) EBITDA, TTM adjusted EBITDA, and TTM pro forma adjusted EBITDA. You’ll hear many different flavors and versions used differently.
How people define EBITDA can vary pretty wildly too. As a result, it’s always good to lay a foundation with your accountant and your prospective buyers so everyone is on a level playing field.
The items I include in adjusted EBITDA may be another person’s pro forma adjusted EBITDA. There’s no right or wrong. I’m not an accountant, nor do I pretend to be one. And when I ask accountants or read investment guides about what should be included, I never get uniform answers.
At the end of the day, everyone agrees what EBITDA is. When you add words or acronyms in front of the term, however, the water gets a little murky, so make sure everyone understands your numbers and is on the same page.
EBITDA is a Game
To keep things simple, the way I like to think about it is this: as-reported or plain old EBITDA is what it is. Adjusted EBITDA adds back one-time anomalies that occurred in the period, and pro forma adjusted EBITDA includes any forward-looking projections.
No matter how you slice it, EBITDA is a game, and how well you understand and play it will have a direct impact on the purchase price you receive when selling your business. Presenting buyers with these numbers early in the process adds credibility in your quest for maximum value. You’ll be seen as a sophisticated seller who shouldn’t be toyed with.
For more advice on how to present your business’ financial picture to prospective buyers, you can find The Exit-Strategy Playbook on Amazon.