Selling a business is a challenging and potentially emotional decision. Owners take into account many factors when determining the asking price. Buyers may look at different factors when weighing the fairness of the price. One valuation metric, EBITDA, provides a useful starting point for measuring value to a buyer. Owners should understand how this metric works before sitting down with investors or buyers.
What is EBITDA?
EBITDA stands for earnings before interest, tax, depreciation, and amortization. This common indicator measures the company’s financial performance. The simplest EBITDA calculation adds non-cash expenses of depreciation and amortization back to operating income:
Operating profit (EBIT)+Depreciation(D)+Amortization(A).
Eliminating non-operating effects that are unique to each company, this calculation assesses operating profitability. This can be especially important when comparing companies in different industries or across tax brackets.
Using EBITDA for Valuation
Successful sellers have a clear understanding of how investors assess value. Valuation usually comes down to an earnings multiple. EBITDA is a relatively useless statistic on its own, since there is good reason behind amortization and depreciation of assets. Adding non-cash expenses back can paint a misleading financial portrait.
That’s what adjustments are for. EBITDA is a non-GAAP figure, which means what is or is not included is discretionary. You might devalue tangible assets and add intangible assets. Companies often adjust included calculations at each reporting period.
Small business owners who want to assess value should analyze EBITDA alongside other important factors, such as changing working capital requirements, net income, debt payments, and capital expenditures.
Using EBITDA to Negotiate Deals
Companies in high-growth industries can expect significant premiums. Buyout offers may be several times higher than the most recent EBITDA figure. In most industries, the multiple is four to six times EBITDA.
Prospective investors and buyers typically push for lower valuations, often by using an average of EBITDA over the past several years.
Small business owners seeking high valuations must boost overall performance. This includes preparing high-quality financial statements. Poorly maintained financial documents send the wrong message about your commitment to the business and your knowledge of its financial situation. Clear and compelling numbers rooted in cold, hard facts also greatly reduce the probability of missing something that might work in either party’s favor.
The right changes to operations, such as cutting unprofitable expenses, increasing sales, and penetrating new markets, may also increase value.
Even then, valuation gaps are common. When this happens, owners must be prepared to demonstrate why their ROI and growth potential justify higher EBITDA multiples. A solid strategic plan that showcases the business’s potential, mitigates risk, and puts into place an exceptionally talented team can get you closer to this goal. Buyers hate risk. Minimize the risk of a purchase and watch valuation increase.