During any deal, a crucial first part is finding a fair purchase price that accurately reflects the value of the business being sold. One key element of this process is determining the ‘EBITDA’ – earnings before interest, taxes, depreciation, and amortization) of the business, also known as ‘Seller’s Discretionary Earnings’ in smaller businesses without professional management. Why is the EBITDA so important? For the simple fact that for most transactions, the business is valued using a multiple of the EBITDA value in order to calculate a purchase price. For a business making a typical $1MM EBITDA, placed at a 4x multiple, the business would be valued at a simple $4MM.
Now what about when that $1MM EBITDA is not really $1MM in EBITDA? That’s the concern we’re seeing much more in deals today as many businesses are being marketed with EBITDA and add-backs manipulated in a way that artificially inflates the value of the business.
To understand why this is happening (and what x10 Ventures recommends our buyers do about it), it’s helpful to fully understand the recent environment for business sales. During the COVID era, business sales boomed as millions of budding entrepreneurs left corporate and either started up businesses (and never went back to the office). This in effect pushed up the multiples for business sales and created a marketing free-for-all among brokers and intermediaries. Business transitions boomed and all was well until Q1 of 2022.
“MANY BUSINESSES ARE BEING MARKETED WITH EBITDA AND ADD-BACKS MANIPULATED IN A WAY THAT ARTIFICIALLY INFLATES THE VALUE OF THE BUSINESS.”
What happened in the 1st quarter of 2022? Pandemic-fueled inflation had gotten so high that the Federal government stepped in and started raising interest rates – and quickly! That started having the intended effects of cooling off inflation but also cooled off the heat of business transactions. While multiples have stayed relatively solid, transactions have slowed and intermediaries have started to get creative with a lower quality of earnings.
Let’s step back and take a more definitive view of the term ‘add-backs’. Traditionally, add-backs are adjustments made to the EBITDA calculation to account for expenses that are not considered to be representative of the ongoing operations of the business. For example, if a company had a one-time legal settlement that significantly impacted its earnings in a given year, the company could legitimately add-back the costs of the legal settlement to the EBITDA calculation to provide a more accurate picture of the company’s underlying profitability. The thinking is, that lawsuit was a one-time item, is not likely to repeat, and will not affect the ongoing operations of the company. So from a Generally Accepted Accounting Principals (GAAP) standpoint, this add-back is completely acceptable and it’s unlikely that the buyer and seller would disagree with that.
“FAR TOO OFTEN, COMPANIES ARE TRYING TO ‘DOUBLE-DIP’ IN THE ADD-BACK ARENA, BY TAKING THE BENEFIT OF THE EXPENSE, BUT ALSO WANTING THE BENEFIT OF THE ‘ADD-BACK’ TO EBITDA. WE ADVISE OUR CLIENTS THAT SELLERS CAN’T HAVE IT BOTH WAYS.”
But what happens when the add-back relates to something in a bit more grey area – like a company retreat? If these are add-backs being claimed by the listing broker or seller, it’s critical to get a detailed accounting of all of the add-backs being claimed and their rationale. In the case of an annual retreat, if the event taking place (or not) would have a material effect on morale, revenue, or any other relevant business KPI, then it’s hard to argue that this is not related to the ongoing operations of the business. Now if the company had a history of retreats, and one year was particularly excessive (and expensive) due to a banner year, and the next year returned to average levels, then the seller could argue that the ‘excess’ in the company retreat (the more expensive year compared to the average year) expense could be added back. This can then become a point of negotiation and if the buyer is really happy with the deal, they can choose to accept these add-backs with or without a concession.
Fast forwarding to 2023 deal flow, and we’re seeing far too many deals with questionable add-backs and rationale behind them. For example, if a company upgraded to a new computer system in 2021, the implementation of that computer system, as well as the training of their personnel, would be considered ‘one-time’ items and would be added-back to the EBITDA calculation for the 2021 year. If the company then decided to have some upgrades or maintenance done to the system in 2022 to reflect customary changes in their business, then they would not be able to add-back those expenses. The new computer system is now part of their operations and the maintenance of the system is clearly an operating expense at this point. Far too often, companies are trying to ‘double dip’ in the add-back arena, by taking the benefit of the expense (in this case the improvements in efficiency with the new computer system upgrades), but also want the benefit of the ‘add-back’ to EBITDA. We advise our clients that sellers can’t have it both ways.
“WE’RE SEEING FAR TOO MANY DEALS WITH QUESTIONABLE ADD-BACKS.”
In conclusion, what’s the impact on the market and guidance to those new to business acquisitions? The impact is the erosion of trust in both the quality of earnings for listed businesses, as well as the intermediary community. In many of the deals that we’ve worked on, the intermediary is knowingly marketing these businesses at inflated prices based on ‘cooked’ books and EBITDA that would not pass Generally Acceptable Accounting Practices, or GAAP. That’s not just bad for sellers, it’s bad for the industry in general.
Brian Malloy
x10 Ventures, LLC