Chances are you haven’t been tracking normalized EBITDA (earnings before interest, taxes, depreciation and amortization) at your business on an annual basis. Why would you need to tinker with how your financial statements look anyway? If you’re being honest, you might say there’s something about “normalizing” that sounds a bit sketchy. Even if you understand the general idea behind normalized EBITDA, it can still be far from obvious how to apply it to your own Income Statements and Balance Sheets.
In this article, we’ll cut through the confusion around normalized EBITDA. We’ll discuss why this metric matters to buyers, and how the exercise of normalizing EBITDA is done (and not done). We’ll also look at how normalizing EBITDA can have a positive impact on the value of your business and its ability to get through the due diligence process when it comes time to sell.
But first, let’s address a common question that many business owners ask or think about asking: Is there something fishy about normalizing EBITDA?
There’s Nothing Weird About “Normalizing” EBITDA
Normalizing, adjusting, or recasting your numbers prior to selling your business may sound like financial manipulation — a bit of trickery to pump up net income and get a buyer to pay more.
In reality, normalizing your financial statements is exactly the opposite. Finding normalized EBITDA is consistent with what should be the primary goal of the entire sale process: Complete transparency.
Going through the exercise of normalizing EBITDA brings true operating income into focus for a buyer. It should also have the net effect of increasing the value of your business. Not only is there nothing fishy about normalizing your financial statements for a buyer, but it is also expected.
If you don’t go through the exercise of normalizing EBITDA for your business then a buyer will. It is something you’ll want to do as part of an overall plan to prepare your business for sale. In fact, if you don’t normalize your financial statements – and the buyer has to ask for this information – you may actually look like you’re trying to hide something. At the very least it telegraphs a sense of apathy.
Buyers Want to See Normalized EBITDA for Your Business
It’s standard practice to value a small business based on normalizing EBITDA and applying an EBITDA multiple. There are, of course, a number of different ways to value a business, some of which are specific to certain types of businesses or industries. For example, the value of a high-growth startup in the technology sector may be based on a forward-looking metric, like discounted cash flow (DCF). There are also industries — like insurance, accounting, and financial advisory — where finding enterprise value based on gross revenue is considered the norm.
The vast majority of small businesses, however, are valued using a deceptively simple formula: Value (purchase price) = EBITDA x Multiplier. If this is the way buyers analyze business value, then sellers need to fully embrace this methodology as well.
EBITDA Is the Norm When Pricing a Small Business For Sale
Legendary investor Warren Buffet has not been held back when it comes to his true feelings about EBITDA. In short, he cautions against using it to value companies, including potential acquisition targets at Berkshire Hathaway.
One of Buffett’s problems with EBITDA is that it eliminates depreciation, which he views as a very real business expense.
When you hear prominent investors like Buffett malign EBITDA remember this: They are referring almost exclusively to publicly traded companies and/or C corporations. These companies are held to Generally Accepted Accounting Principles (GAAP), are taxed at the corporate level, and are bought and sold using stock purchase agreements.
The vast majority of small businesses, on the other hand, are not publicly traded and are not even C corps. Most are structured as pass-through entities, namely a limited liability company (LLC) or S corporation. The books are not audited using GAAP, they are taxed at the owners’ ordinary income level, and are bought and sold primarily through asset sale agreements.
The very nature of a pass-through entity forces business owners to consider how their business and personal income tax returns affect one another. For better or worse, the personal finances of a business owner and the financial workings of their business are closely intertwined. Savvy buyers know this, which is why they want to see EBITDA for the business, along with acceptable adjustments.
Normalized EBITDA: The House Without You In It
The primary goal of normalizing EBITDA is to give buyers a true picture of earnings from operations at your business. There may be several expenses on a Profit & Loss Statement (P&L) — personal and business — that aren’t integral to business operations. They are unique to the owner, their personal financial goals, and the subsequent management decisions they’ve made along the way.
When you sell your business you’ll want to demonstrate what it looks like independent of you: Normalized financial statements help paint this picture for potential buyers.
Think of removing all the family photos from your house when it’s being staged to sell. Buyers need to see what the business will look like to them — without you in it. A new owner may use profits differently than you have. They may take on more or less debt and pay more or less interest expense. Their depreciation schedule will not be the same as yours. And they may choose not to offer perks to family members who are not involved in daily operations.
Buyers are also an investment-minded lot. In an effort to determine their return on investment from acquiring your business, they need to get a crystal-clear picture of all cash flow available from operations.
Normal EBITDA Adjustments
When you’ve been running your business for decades, you tend not to notice (or perhaps have forgotten) all the ways in which you run the business that are unique to you. This could include discretionary personal expenses — part of the perks of ownership — that are more pronounced in smaller Main Street businesses. Normalized EBITDA for these smaller businesses is typically referred to as seller’s discretionary earnings (SDE). Using the term SDE signals that the owner has been running both compensation and lifestyle expenses through the business’ P&L.
Adjusted or normalized EBITDA tends to be a somewhat cleaner metric than SDE, used for lower middle market businesses rather than Main Street. Add-backs used to normalize EBITDA fall into several categories, all of which are themselves considered normal (i.e., acceptable) by buyers. The big caveat with all adjustments is that the seller must provide documentation to support them.
Adjustments made to the P&L to normalize EBITDA include:
ADJUSTMENTS TO INCOME
- Income from redundant assets (assets owned by the company that don’t contribute to revenue-generating activities)
- Rebates or discounts that will not transfer to a new owner (also referred to as non-arm’s-length dealings)
ADJUSTMENTS TO EXPENSES
- Owner’s Salary: Adjustment up or down, normalizing to an appropriate market-based salary for the role the owner fills in the organization (e.g., CEO, Sales & Marketing Director, Operations Manager, etc.).
- Owner’s Payroll Expense: Adjust up or down to align with market-based salary, above.
- Owner’s Benefits: It is customary to add back the owner’s health, life, and auto insurance expense. However, this is sometimes questioned by buyers if they would have to offer similar benefits to your replacement.
- Payroll: Remove compensation for shareholders or family members not involved in daily operations. Also, adjust up or down for family members working in the business who receive above or below a fair-market salary for the work they perform.
- Fair Market Rent: Adjustment up or down, normalizing to fair market value for rent if the real estate is owned by the business, or a related third party (e.g., a separate Trust or LLC owned by one or more of the shareholders).
- One-time Expenses: These are typically unexpected expenses, like clean-up and repair from an accident not covered through insurance claims.
- Non-recurring Expenses: These may be correlated to a business expense account, but would not be repeated. For example, a large marketing expense for the company’s 20th-anniversary celebration. Extraordinary legal or professional fees can also fall into this category, as do sunk start-up costs for a new product or service.
- Personal Expenses: Add back any expenses that are strictly personal in nature, like travel expenses or club memberships.
Again, the goal of this exercise is to paint an accurate picture of profitability from business operations: Normalized EBITDA should reflect all cash flow from operations available to a new owner.
Avoid “Abnormal” Adjustments to EBITDA
Avoid the temptation to try and add back as many expenses as possible to increase EBITDA and command a higher business valuation. Even if you can provide supporting documentation, running loads of personal expenses through your business speaks volumes about your priorities. A laundry list of unreasonable normalizing adjustments will set off alarm bells with buyers who will then go looking for saner investment opportunities.
This is one of many reasons to hire a merger and acquisition (M&A) professional, like a business broker or M&A advisor, to normalize your financial statements and help prepare your business for sale. It takes a trained eye to know which normalizing adjustments will pass muster with buyers.
Track And Manage Normalized EBITDA … Now!
There’s no need to wait until you’re ready to sell to learn how buyers will view normalized EBITDA for your business. Working with an experienced business broker results in cleaner financial reporting and better data for decision making in both the short and long term.
The advisors at Allan Taylor & Company work with small business owners well in advance of selling a business. Reach out today to learn more about increasing the value of your business, and preparing for a future sale.