When selling a business, adjusted EBITDA (Earnings before interest, taxes, depreciation, and amortization) can have a significant impact on valuation. If a buyer values a company based on a multiple of EBITDA, every legitimate dollar of additional EBITDA may translate into several dollars of enterprise value. For additional context on the distinction between enterprise value and the cash ultimately received by a seller, see Persient’s blog, “The Net Debt Analysis and Its Impact on Enterprise Value.”
But there is an important word in that sentence: legitimate.
Sellers understandably want to identify expenses that overstate the ongoing cost structure of the business. Buyers, meanwhile, want confidence that they are paying for earnings that actually exist and are sustainable under new ownership.
The result is that seller-adjusted EBITDA and buyer-accepted EBITDA can be two very different numbers.
Consider a hypothetical company generating $4.0 million of reported EBITDA. The seller identifies $1.0 million of proposed adjustments and presents $5.0 million of adjusted EBITDA. At an illustrative 7.0x multiple, that difference represents $7.0 million of enterprise value.
The relevant question is not simply how much adjusted EBITDA a seller can present, but how much of that EBITDA can be supported during a buyer’s diligence. That does not mean sellers should be conservative for the sake of being conservative. A legitimate adjustment left unidentified can have a meaningful impact on perceived value. But historical normalization, projected improvements and buyer-specific synergies are different concepts, and sophisticated buyers are likely to treat them differently.
Some EBITDA Add-Backs Are Relatively Straightforward
A common example is a true personal expense being run through the business.
If a business owner has personal automobile, travel, club membership or other bona fide personal expenses flowing through the company’s income statement, and those costs will disappear following a sale, an adjustment may be appropriate.
Owner compensation is another common example, although the analysis can be more nuanced.
Suppose, hypothetically, an owner receives $800,000 in annual compensation, while a qualified replacement executive is reasonably expected to cost $300,000. Simply adding back the entire $800,000 would overstate normalized EBITDA because someone still has to perform the owner’s job. The more relevant analysis may be the $500,000 difference, subject to the specific facts surrounding responsibilities, salary, bonuses, benefits and other employment costs.
The same analysis can work in reverse. If an owner takes substantially below-market compensation, a buyer may argue that normalized EBITDA needs to be reduced to reflect the actual cost of replacing that individual. Normalizing EBITDA is not supposed to be a one-way exercise.
“One-Time” Expenses Are Not Always So Simple
Nonrecurring expenses are another frequent source of EBITDA adjustments.
A truly isolated legal expense, one-time professional fee or unusual event may reasonably warrant consideration. But labeling an expense “one-time” does not necessarily settle the question.
Imagine a business with a different unusual expense every year:
- Year one includes a major systems implementation.
- Year two includes unusually high recruiting costs.
- Year three includes relocation expenses.
- Year four includes significant professional fees.
Each individual expense might truly be nonrecurring. A buyer may nevertheless ask whether some level of unusual expense is a recurring feature of operating the business.
In other words, there is a difference between asking whether this particular expense will recur and asking what costs are reasonably required to operate the company over time.
When an Add-Back Becomes a Pro Forma Adjustment
The analysis becomes more challenging when sellers move from normalizing historical results to giving themselves credit for things that have not yet occurred.
Imagine that a company recently wins a significant new customer. Management estimates the relationship could generate $500,000 of incremental EBITDA annually.
Is that $500,000 an EBITDA add-back?
Not in the same sense as removing a documented personal expense from historical results. It represents potential future earnings rather than an expense embedded in historical EBITDA.
Similar issues arise with proposed headcount reductions, anticipated price increases, future efficiencies and other planned cost savings.
None of those items necessarily lack value. A buyer may consider them when evaluating the company and its future earnings potential. But presenting anticipated benefits as though they are indistinguishable from historical normalization can create unnecessary disagreement during diligence. Historical normalization and pro forma adjustments answer different questions. Normalization considers what the business has historically earned on a representative basis, while a pro forma adjustment considers what the business may earn under different circumstances. Both may be relevant to value, but they should not necessarily be presented in the same way.
Add-Backs That May Raise Eyebrows
There is nothing wrong with advocating for legitimate EBITDA adjustments. In a sale process, sellers should make sure buyers understand the company’s true earnings power. But there is a point at which an adjustment begins to look less like normalization and more like an aspirational business plan.
Giving full credit for new revenue with little or no associated cost.
Suppose a company recently wins $1 million of new annual business and expects a 30% EBITDA margin once the work is fully implemented. Adding the entire $1 million to EBITDA would ignore the costs required to generate that revenue. Even adding the expected $300,000 of EBITDA involves assumptions about timing, customer purchasing levels, labor, materials and other costs that may not yet be reflected in historical results. The opportunity may be real, but it is still different from adding back a documented personal expense.
Adding back positions that have not actually been eliminated.
Management might identify $600,000 of payroll it believes can be removed without affecting operations. If those employees are still on the payroll, however, this is not a historical add-back. It is a proposed future cost-saving initiative. The savings may be achievable, but they should be distinguished from normalized historical EBITDA.
Treating recurring “one-time” expenses as though they never happen.
If some amount of restructuring, recruiting, consulting, litigation, systems work or other exceptional spending consistently finds its way into the income statement, a buyer may question whether eliminating all of it presents a realistic picture of ongoing earnings.
Adding back an owner’s entire compensation without recognizing the job performed.
An owner may leave after the transaction, but the responsibilities usually do not disappear with the individual. If a business must hire a CEO, salesperson, operations executive or other employee to perform those functions, that replacement cost matters.
Taking credit today for tomorrow’s improvements.
Planned price increases, future purchasing savings, anticipated automation benefits and facility consolidation may represent legitimate upside. What makes them different is that the benefits have not necessarily been realized in the historical financial statements.
There is an important distinction between saying “this expense is not part of normalized operations” and saying “we believe the company can become more profitable.” The second argument may be compelling. It simply is not the same argument as an EBITDA add-back.
Buyer Synergies Are Not the Same as Standalone EBITDA
Suppose a strategic buyer already operates nearby and could consolidate the seller’s facility into its own operation. Or perhaps the buyer believes it can eliminate duplicative corporate costs following the acquisition.
Those potential savings can make the business more valuable to that particular buyer. But they are not necessarily adjustments to the company’s standalone historical EBITDA.
Sellers should understand and, where appropriate, negotiate around strategic value. But potential buyer synergies and normalized standalone earnings answer different questions. Mixing them together can obscure an otherwise compelling EBITDA story. The further the analysis moves from historical normalization toward pro forma earnings and buyer synergies, the more it shifts from asking what the business has earned to asking what the business could earn.
Aggressive Add-Backs Can Become a Credibility Issue
The danger of aggressive adjustments is not limited to the dollars being challenged.
Imagine a seller presents ten adjustments to EBITDA. Several are readily identifiable and well documented, while others depend heavily on forecasts, contemplated cost savings or aggressive assumptions. The buyer and its accounting advisors now have to determine which adjustments they consider supportable.
That can shift the diligence discussion away from the strength of the underlying business and toward the credibility of the EBITDA bridge. A weak adjustment may also invite more scrutiny of otherwise legitimate ones.
For that reason, sellers should not necessarily measure success by how many adjustments they can identify. A better objective is the highest defensible EBITDA. That can mean being aggressive about finding legitimate normalization items while being disciplined about distinguishing them from projected growth, future cost reductions and buyer-specific synergies.
The Five-Question Add-Back Test
1. Did the expense actually occur? Separate historical fact from forecasts and future opportunities.
2. Will the expense genuinely disappear? If someone or something must replace it, consider the replacement cost.
3. Is it actually nonrecurring? Look beyond a single year and consider the company’s historical expense pattern.
4. Can the adjustment be documented? Buyers and diligence providers will want to understand the source and calculation.
5. Is it normalization or future upside? Both may matter to value, but they should not necessarily be presented the same way.
The Best Add-Back Is One You Can Defend
Sellers should be thorough in identifying legitimate adjustments. Leaving a defensible add-back unidentified can unnecessarily understate the company’s earnings profile.
At the same time, the goal should not be to produce the highest possible adjusted EBITDA. It should be to develop the highest defensible adjusted EBITDA.
An earnings analysis filled with aggressive forecasts, questionable “one-time” expenses and buyer-specific synergies may invite greater scrutiny of the entire EBITDA bridge. A thoughtful analysis that clearly distinguishes historical results, legitimate normalization adjustments and future opportunities gives buyers a clearer earnings story.
For business owners considering a sale, reviewing potential EBITDA adjustments before going to market can help identify issues early and prepare for the scrutiny that may come during a buyer’s quality of earnings process. Persient discusses the potential benefits of preparing before buyer diligence in “Sell-Side Quality of Earnings (QofE) Analysis.”
Ultimately, adjusted EBITDA is not just an accounting exercise. In an M&A transaction, it is a negotiation about what the business really earns and what level of earnings a buyer is willing to pay for.
