It's not the only number potential buyers look at, but EBITDA will give you a solid idea of how they'll start evaluating your business.
Looking to the future, can you envision a time when you might want to sell your business?
"The best way to build a company is to build it as if you're going to sell it," says veteran entrepreneur and Inc. columnist Norm Brodsky. "It has to be built to last."
One place to start measuring your company's potential value in a sale is determining your EBITDA, or earnings before interest, taxes, depreciation, and amortization. It's certainly a mouthful, but the equation itself is really quite simple: subtract expenses from revenue (excluding interests and taxes) without depreciation and amortization (what you pay for tangible and intangible assets). The remaining number paints a basic picture of your profitability as well as your ability to pay off what it owes.
"It's a quick and dirty way to assess the firm's ability to pay back interest or debts," says Gil Sadka, assistant professor of accounting at Columbia Business School in New York. Sadka calls EBITDA a "quasi-estimate" of your free cash flow, a more traditional and comprehensive assessment of a company's performance. You can get a more accurate reading of your free cash flow by subtracting out new capital expenditures for that year. Once you get this dollar amount, simply build upon the foundation to see how well you are doing.
Understanding EBITDA: Add and Subtract Value
It's unlikely that you as the business owner would be fiddling around with your company's EBITDA. Still, before you sit down with the buyers or investors who will, it's important to understand what they'll be looking at.
Essentially, EBITDA on its own makes for a fairly futile statistic. There is, after all, a very good reason why you depreciate and amortize assets. To simply put those charges back in to earnings may give an unrealistic measure of your finances.
That's where the need for adjustments comes in. Since EBITDA is technically a non-GAAP figure, meaning it does not conform to generally accepted accounting principles, you can make these adjustments almost wherever you see fit. As just mentioned, you might need to devalue assets like old equipment within the overall number. Likewise, you also might have failed to collect some accounts receivables from clients. These result in a net-negative for your operating cash flow.
By the same token, you can also add both tangible assets (like equipment) and intangible assets (like your management team and employees) to the figure. It's typically through this addition process that you arrive at your company's value as a multiple of EBITDA. Let's say you pay yourself a $300,000 salary for a position that someone – like a buyer or competitor – could do for $150,000. That buyer would then add that extra $150,000 back into the value of your company once its absorbed. In this case, the number you arrive at is a form of adjusted EBITDA called "field" EBITDA, where you take into account subsidiaries and components of a company that can be absorbed for little to no cost. The term most often applies when selling the business to one in a similar field, in which case the management team, office space, and other business expenses may fall by the wayside during the takeover.
Understanding EBITDA: Seek Outside Opinions
You can tinker with the formula all you like. But how will you know what calculations are safe to assume and which aren't? How do you put a price tag on your company's competitive advantage, list of customers, and your brand as a whole?
There are endless variables and measurements that factor into your company's worth. One way to gauge interest is to approach potential buyers in your industry. Five years before selling his records storage business, CitiStorage, Brodsky did just that. At first the buyers' responses were curious, Brodsky recalls "They laughed and asked, 'Well, why would we do that?'" Yet eventually he convinced them that he'd consider their interest in the imminent sale of his company.
After getting this valuable input, Brodsky reformed the areas of his business that could pump up his multiple of EBITDA or purchase price. This meant taking care of contracts that were out of date and fortifying his management team. In the end the strategy worked: Brodsky sold CitiStorage in 2007 for 10 times the value of EBITDA. "I wasn't planning on selling for quite some time, but I really wanted to know how I could get the most for my company," Brodsky says.
There are a number of other resources you can use to estimate the value of your company. Business Valuation Resources, for instance, provides you with comparative and historical information within your industry. Experts agree, though, that EBITDA does depict an accurate comparison across markets because of the exclusion of interest and taxes that vary by sector. Making the right changes – cutting unprofitable costs, expanding sales, or reaching new markets – can have a significant effect on EBITDA as a measure of your performance.
At this point a simple question remains: which year's EBITDA are we talking about, the current, past, projected, or a combination? Buyers, of course, will be pushing for a lower valuation and might look at an average of EBITDA over, say, three years as the base number. To get the highest valuation, you'll want to bolster gains in the present and future. To do so, be sure to exceed your business plan and monthly goals, create a solid sales stream into next year, and get clients on-board with long-term contracts. Don't exaggerate too wildy, though: sophisticated buyers will always cut through the grease.
Understanding EBITDA: Proceed with Caution
EBITDA, of course, shouldn't be the only consideration when it comes to your company's value and strength. You'll want to factor in a handful of other metrics like capital expenditures, synergies, and other financial accruals, though you may want to leave those evaluations to the accountant.
Nonetheless, it's important to understand that EBITDA has its flaws. You don't want to put too much emphasis on it when looking at the strength of your business because it doesn't consider risks like the potential for future growth and your mix of customers. Having three huge customers that each account for 25 percent of your business, for example, is a lot riskier than having a mix of smaller customers that only account for 6 percent each. Diversity among clients and demonstrable potential to capture greater market share will both add value to your business in the long run.
"Every time you make an adjustment, you have to be careful on the other side," Sadka says. In essence he means you have to be able to mathematically prove why adjusting for client diversity, or good will, or future sales, makes sense. "You have to explain every adjustment, and why there is real value there."
Interest rates also play an important role in determining the multiple of EBITDA you warrant as well. This is why price-makers or lenders divide your interest payments by EBITDA to find out your risk in paying back debts. The more cash you have available to pay off interest, the less risk you take on as a company, and thus the greater your value. In addition, as interest rates rise, your value tends to fall because it suddenly became more expensive to pay off those debts. In the fortunate instance they fall, however, your value will only rise – thereby presenting the most opportune time to make your sale.