What are EBITDA add-backs?
EBITDA add-backs are mainly used in an M&A transaction when the business owner tries to sell his company. Financial and investment professionals will make multiple EBITDA adjustments to reflect the company's operating profitability more accurately. Once all the add-backs are made, you have an adjusted EBITDA.
These add-backs are primarily exceptional one-time expenses and are not expected to happen again. The resulting adjusted EBITDA is used to determine the "true" earnings of a company.
The major categories of EBITDA add-backs are nonrecurring expenses and owner compensation. Other adjustments are personal expenses and negative add-backs, such as exceptional income unrelated to business operations.
What is EBITDA?
If you've never spoken with Investment Bankers about selling or raising capital for your business, you've probably never heard about EBITDA.
A company's EBITDA is a crucial metric widely used by financial and investment professionals operating in the lower-middle market segment. It is found on the company's income statement and is a quick proxy for the company's ability to generate cash.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization and is used to assess the company's profitability.
It is calculated by taking operating income and adding back interest expenses, taxes as well as depreciation and amortization.
Depreciation and amortization expenses are added back from net income because they are abstract accounting expenses and don't affect the business's cash flow. Interest expense is added back from net income to exclude the effects of capital structure and to make companies more comparable.
EBITDA add-backs can increase business valuations
An EBITDA multiple is often used to derive the Enterprise Value, which means that you multiply your EBITDA with a transaction multiple to derive the Enterprise Value. So, identifying valid EBITDA adjustments can massively increase business valuations.
For example, EBITDA adjustments of around USD 500k can result in a valuation increase of USD 5m, assuming a typical 10x EBITDA multiple. This increase in Enterprise Value will directly affect the purchase price. Thus, business value is significantly influenced by a couple of valid EBITDA adjustments.
How to calculate adjusted EBITDA
Calculating adjusted EBITDA starts with the regular EBITDA or "reported EBITDA". Then, you would add back nonrecurring expenses to accurately identify EBITDA increases.
We are talking about exceptional expenses that aren't expected to happen again. This will help represent the company's earnings more accurately as discretionary expenses are added back.
Good rule of thumb
Will these identified expenses reoccur under new ownership post-acquisition?
If not, then these are considered legitimate deductions to the adjusted EBITDA.
The potential buyer will not accept the proposed deductions if the company will most likely incur the identified expenses post-acquisition.
Common EBITDA add-backs
Here are a couple of common add-backs that you can put on your list for your adjusted EBITDA:
Nonrecurring expenses
Nonrecurring expenses are expenses that are not expected to happen again. These expenses result from one-time and exceptional events.
There is some wiggle room. For example, your business repeatedly has lawsuits and, for some reason, such lawsuits are expected to continue. In this case, you cannot add those costs to your adjusted EBITDA. They are part of ordinary business operations and must be included in operating expenses to reflect true operating performance. Such lawsuits are expected to happen again regardless of a new owner.
The list below is a good starting point. Each item below should be examined, whether they are discretionary or recurring. If they are truly one-of-a-kind, they can be added back to the adjusted EBITDA:
Legal fees and litigation expenses
Consulting fees
Restructuring expenses
Transaction-related costs, such as accounting, management consulting or legal
Facility relocation or renovation expenses
Relocation expenses
Charitable contributions
Owner compensation and benefits
Many owners of private companies give themselves excess wages and bonuses. There is nothing wrong with paying yourself generous salaries while you own the company. However, the new owner will unlikely pay himself such a generous salary.
Therefore, a case can be made to add back the difference between a generous salary and a fair market salary.
For example, if the old owner paid himself a salary of USD 500k and the industry benchmark for similar positions is USD 200k, we can make the case to add back USD 300k to the adjusted EBITDA. Conversely, if the old owner paid himself USD 100k, there would be a negative adjustment of USD 100k to arrive at a fair market salary.
When adjusting for excess compensation, it is also essential to consider all benefits related to owner compensation, such as travel or car allowances.
Other personal expenses
Here, we are talking about the discretionary expenses of the business owner. Often, these are personal expenses run through the company to reduce tax liability. These are the financial benefits of reducing the business's earnings and corporate income taxes.
Many personal expenses are not expected to continue with a new business owner. Thus, these expenses should be added back to the adjusted EBITDA. Here are some typical items:
Family members on the payroll that are not working in the business and are expected to leave company once it's sold
Above-market salaries paid to relatives
Travel, meals and entertainment expenses unrelated to actual business development
Negative add-backs
Not all EBITDA add-backs automatically increase the earnings of your company. The purpose of these add-backs is to reflect the company's operating profitability going forward with new owners.
In some cases, negative add-backs are necessary to derive the actual earning ability:
Exceptional income, such as insurance recoveries, unrelated to business operations
The business owner personally owns the real estate property, charges below-market rent and is unwilling to pass on these favorable terms. In that case, the difference in rent expense would reduce the adjusted EBITDA to reflect the adjusted costs to new owners
The business owner does not intend to sell all the business's assets as part of the transaction. In that case, the adjusted EBITDA must be reduced to reflect the actual earning ability of the sold assets
EBITDA add-backs that are not accepted
The list above gave us a lot of items that may be valid add-backs to the company's adjusted EBITDA. However, certain expenses are not accepted as they inaccurately inflate the company's operating income and net earnings.
Are discretionary expenses actually one-of-a-kind?
This is the core question. Will the identified add-back expense likely happen post-acquisition? If yes, the add-back will not be accepted by the potential buyer and cannot be added to the adjusted EBITDA.
For example, you want to add back the set-up costs of a retail shop. You argue that these expenses are exceptional and nonrecurring once the shop is set up. However, growth in your business plan is driven by launching new retail shops. So, these set-up costs are integral to your business plan and cannot be deducted from the adjusted EBITDA.
