You, the business owner, must be able to support and defend what the true EBITDA is of your business. What is EBITDA? EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA can determine the value of your business. Prospective buyers will scrutinize every aspect of EBITDA to determine the financial strength of your company. This will take place through what is called a Quality of Earnings (QOE) Report.
During the due diligence process in acquiring a business, potential buyers will receive numerous documents that outline the financial and operational health of your business. You must invest time in the process of disclosing as much accurate information as you can to support the true EBITDA of your business. To ensure the highest and best acquisition price, it is important to make sure that information is fully disclosed and supports the actual quality of financial and operational health.
EBITDA is one of the most common ways to value a business based on multiples of that number. When selling your business in the open market, you should expect that any potential buyer or investor would perform a review of your income statement for adjustments. They will want to arrive at an adjusted EBITDA that makes sense for THEM.
You need to be ready to support what the true Adjusted EBITDA is that serves as the basis for a purchase price of your business. This value will be used with a multiple to negotiate a final price and terms that make sense for you and the potential buyer. Take as an example: If you miss out on the correct EBITDA for your business by $100,000 on a 2 multiple, you just gave up $200,000 in acquisition cost of your business.
Here are three common EBITDA adjustments:
- Items related to conversion based on a GAAP Accounting basis (General Accepted Accounting Principles); this number can have a considerable range.
- One-time events such as insurance settlements, legal expenses, and unusual expenses associated with issue/growth of the business.
- Certain personal expenses a business owner takes what would typically not be part of the future cash flow of your business.
When it comes to representing the financial health and aspects of your business it is important not to ignore balance sheets. A balance sheet needs to be recast in a way that the potential buyer understands the assets and liabilities that transfer in a sale. It is best to recast the balance sheet upfront to what truly transfers with the business. If you don’t, the end result can be items popping up during due diligence causing delays in negotiations.
For example: business owners may park large amounts of cash in their business and on their balance sheets – over and above what is normally necessary. When a potential buyer sees a $1,000,000 cash position on a business when a $60,000 working capital position is needed, they are going to want the $940,000 cash to transfer with the business. This is fine if they are willing to pay $940,000 more for the business. This is not fine if they want the sale price of the business on a “cash free”, “debt free” basis when the business transfers to stay the same with a reasonable sale price.
The same is true with liabilities. If you intend to transfer the business without debt, if $500,000 in liabilities is relieved from the business, the value and burden of debt on the business logically increases by an adjusted amount in cash flow that is not needed by the business moving forward. This mathematically increases the value of the business based on the cash flow used against the multiple used for valuation. For example, if you relieve $100,000 debt service to the business against a 3 multiple for the value equates to an additional $300,000 in value and price that the business should sell.
Here are three key points to keep in mind when planning on selling your business:
- Make sure that managers and key employees are able to step in and run the business during the transition period.
- Review your financials, and get ready for GAAP reporting requirements during due diligence with a potential acquisition.
- Consider having a Quality of Earnings analysis performed with your business before going to market so you truly understand the financial health of your business.
Selling a business is a complicated process. Well organized and solid financials, along with a supported EBITDA and operational health, represents to buyers and investors a sound and well-run business. EBIT Associates provides independent and objective valuation advisory services, which range from merger and acquisition transactions to asset appraisal and strategic planning.