Insights on EBITDA

When a large business owner makes the decision to sell their company, they are frequently met with a number of unwelcome truths. For instance, the owner of a company frequently comes to the realization that the absence of adequate financial data becomes a significant obstacle for the company. When considering the worth of your company, potential purchasers, lenders, underwriters and the SBA will, as a matter of course, delve into and analyze each component of your EBITDA (earnings before interest, taxes, depreciation, and amortization). It is most likely that this will take place through a document that is known as a Quality of Earnings Analysis Report (Q of E) during the due diligence phase of the transaction. Generally Accepted Accounting Principles serve as the primary framework and terminology for the preparation of financial reports (known as GAAP Accounting). sGAAP Accounting and Reports frequently expose significant deviations from the standard practices that the majority of businesses use to manage their general and day-to-day accounting. The ultimate effect of all of this can potentially be a significant change in EBITDA value.

During the phase of purchasing a business known as due diligence, prospective purchasers will ultimately be given access to a large number of documents that provide an overview of the financial and operational health of the business being purchased. This indicates that you, as the owner of a business, must be prepared to commit a significant amount of time in the process of presenting as much detailed information as you possibly can in order to support and defend the maximum EBITDA of your company. To summarize, getting your company ready for sale is no easy task. You need to make certain that all relevant information is available, and you also need to defend the true quality of the company’s financial and operational health in order to achieve the highest and best possible sale price.

The earnings before interest, taxes, depreciation, and amortization (EBITDA) method is one of the most used approaches to valuing larger companies.  There is no universal definition, but generally businesses that have over a million dollars of annual EBITDA.  When putting your company up for sale on the open market, you should be prepared for any potential buyer or investor to conduct a review of your income statement in search of adjustments. This will allow them to calculate an adjusted EBITDA that is appropriate for their purposes in advance of a purchaYou and your advisor need to be prepared to defend the real adjusted or normalized EBITDA because this serves as the basis for the purchase price of your company.

If you underestimated the EBITDA of your company by $100,000 using a sixfold multiple, for example, you have just left $600,000 on the closing table.

There are typically three changes made to EBITDA:

First, elements associated with the conversion based on a GAAP Accounting foundation; the range of possible values for this number might be quite large.
Second, one-time events that occur in connection with the company, such as legal fees, PPP loan forgiveness, insurance settlements, and unusual expenses linked with challenges or growth in the company, can have a significant impact on the adjusted EBITDA figure.
Third, certain personal expenses that a business owner incurs that generally would not be a part of the future cash flow of your company is another potential impact that could be made on EBITDA.

When it comes to expressing the financial health of your organization it’s important to insure accuracy of the balance sheet as well. Too often balance sheets are only updated yearly for tax purposes with only end of period general journal entries.  This does not provide an accurate picture of the company in present time.  When it comes to their primary objective, smaller firms will almost always concentrate solely on profit, which is one of the factors that might lead to balance sheets not being examined as frequently as they should be. It is necessary to reformat a balance sheet in such a way that a prospective purchaser has a thorough understanding of the assets and liabilities that are being transferred in a sale. This requires that general journal entries be made in the month for which the adjustment actually occurred.  It is better to recast the balance sheet upfront to what truly conveys with the business in present time to avoid problems during due diligence.

As an illustration, we frequently notice that the owners of businesses may sometimes keep much more or less cash than is typically required in their organizations and on their balance sheets.   As soon as a prospective purchaser sees that a business has a cash position of $1,000,000 while just a working capital position of $75,000 is required, that purchaser might expect that the cash position of $925,000 be included as an asset. That is OK as long as they are ready to pay an additional $925,000 (referred to as buying cash for cash which can be attractive as the buyer will borrow the incremental funds to maximize liquidity). However, if they want the sale price of the business to be based on a “cash free, debt fee” basis when the business is conveyed, then they are not entitled to the excess cash.

The same can be said for financial obligations. If you plan to sell the company free and clear of any financial obligations, then the value of the company and the weight of its debt will logically decrease the net sale proceeds dollar for dollar. As an example if the debt service on a fleet of vehicles is being recast those vehicles must transfer to the buyer free and clear of encumbrances (debt free – paid off at closing).

Savvy seller will remember these four key issues:

  • Retain expert M&A, legal, Lending and Tax advisors
  • Minimize Key Personnel Issues
  • Insure your Profit & Loss Statement as well as Balance Sheet are GAAP Compliant
  • Be Prepared for a Quality of Earnings Audit During Due Diligence

The sale of a business involves many moving parts and steps that need to be proactively managed at the right time in the correct order. Well-organized and robust financials, such as a defensible EBITDA and operational health, gives the impression to potential buyers and investors that the business is healthy, profitable, and expertly managed by an owner who is both professional and practical in their expectations.

Bottom line? It is never too early to start preparing, even if you anticipate that it will be several years before you put your company up for sale as business buyers, their lenders and the SBA often look to prior periods in making their go : no go decisions.

Copyright: ENLIGN Business Brokers, Inc.

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