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What is EBITDA?

02/09/2021

What is EBITDA and why is it used in the M&A process?

In the first of five videos in our “M&A Deconstructed Series”, focused on demystifying mergers and acquisitions (M&A) and their component parts, Partner and M&A Solicitor at Steele Raymond, Nick Davies, and Managing Director of TheNonExec Limited and M&A expert, Justin Levine, discuss EBITDA and how it is used to understand the financial health of a business during a company sale or corporate acquisition.

Take a look at this in-depth discussion in the video or read through the transcript below…

 

Video sub-topic timestamps:

00:00 – Introducing EBITDA
01:31 – Why is EBITDA important for a business sale?
02:22 – Alternative ways to value a business
02:50 – EBITDA and multiples
02:55 – Monthly financial reporting and EBITDA
03:40 – Adjusted EBITDA working examples
07:20 – Presenting EBITDA objectively
07:55 – Typical EBITDA Multiples per industry
09:36 – Organisations reporting on EBITDA
10:07 – EBITDA and Scalability
10:56 – Higher multiples with intellectual property / Scalability
11:20 – Types of buyers
11:38 – Which buyers typically pay higher multiples?
11:50 – Creating competition and impact on multiples
12:00 – Range of multiples

Video Transcription

What is EBITDA: What does it mean and what is its significance in M&A?

Nick Davies:
Justin, hi. So in the latest video of our series we are going to be talking today about EBITDA, that mysterious acronym. And EBITDA multiples. A very important topic; very interesting topic. We’re going to touch on concepts of adjusted EBITDA as well. Perhaps talk about some multiples which are typical in different sectors. Do you want to open up? EBITDA is very important from your corporate finance perspective.

Justin Levine:
Yes it [EBITDA] is [very important]. The acronym itself effectively relates to operating profit. But, of course, it means something in terms of a mathematical financial term. So, [EBITDA] is “Earnings Before Interest, Taxes, Depreciation, and Amortisation”. Typically, if you look at your statutory accounts, produced by your accountant, you will see an operating profit number in those accounts. Typically, what you have to do is to mathematically adjust that number to get EBITDA. And, inevitably, you’re adding back depreciation, which might be carried in your sales general administration, your overhead number in the accounts. And, you are deriving effectively your operating profit before depreciation, before you’re paying interest, before you’re paying amortisation and so on.

Why is EBITDA important for a business sale?

Justin Levine:
It’s a really important number, because actually the roots of it are; it shows a potential investor or buyer the ordinary cash flows. It’s not a direct correlation, because actually it shows how much cash the business generates before it invests in things like capital expenditure, investing in other activities. It’s an important peg in the ground, as it were, because a buyer can say, “Well, if the business generates £1 million of EBITDAs, it says, roughly speaking that on a steady state basis, the business will generate £1 million of free cash flows over a very long period of time, before the business invests in things like fixtures, fittings, investment, capital expenditure and so on.”

Alternative measures of profitability – what can be used instead of EBITDA?

Justin Levine:
The reason it’s so important is because it forms the basis of most valuations of companies. There’s various ways to calculate or estimate the value of a business. There’s discounted cashflow analysis, there’s net-book value analysis. There are all sorts of revenue multiples that you can look at. But actually as an industry, in terms of the pragmatic, practical realities of life, most buyers value companies based on the EBITDA value of the business, the sustainable operating profits, before depreciation and so on, multiplied by an industry norm, a number.

EBITDA vs Operating Income

Nick Davies:
Are businesses typically in their monthly management accounts, monthly financial reporting … Are businesses typically reporting on and tracking EBITDA? Is that something in your experience SMEs tend to do?

Justin Levine:
That’s a good question and the answer’s no. I think it’s just a black and white version of the answer. So, no. Typically an SME will be looking at operating profits. Very few look at the sophistication of EBITDA. So right from the off that’s an unfamiliar term.

Nick Davies:
It’s a concept that a seller’s got to get to grips with, get an understanding of, right at the beginning of the process?

Adjusted EBITDA

Justin Levine:
That’s absolutely right. And I think then, before we get to the EBITDA multiple, as it were … When you’re selling a company, a buyer is going to be looking at that business to say, what is the sustainable EBITDA, from that business under my ownership and not yours?

Nick Davies:
Yes. So that’s where we’re getting into adjusted EBITDA. In a scenario where a business is particularly cash generative, for whatever reason, the owners, the executive team, might be extracting some of that cash by inflated salaries, for whatever reason. It doesn’t sound very tax efficient, but for whatever reason they might be doing that. But a buyer might be saying, “Well, actually I’ll be putting in a replacement management team, who will be paid at a market rate. Therefore, we won’t be extracting so much of the cash by way of inflated salaries.” So then you get into your adjustments of what does that mean for the EBITDA calculation? Is that a fair assumption?

Justin Levine:
I think that’s a very fair assumption. Typically, my experience is, most owners of SMEs will have some degree of costs, proportionate or disproportionate. It’s their business. They can do as they like that go into that business. And, of course, those costs won’t be there. But equally, in today’s tax regime, it is very atypical that sellers, particularly if they are shareholder operators … They’re involved in the business, they’re perhaps running the business, they typically take their compensation by way of a small salary and usually the rest by dividends, Of course, tax regimes will inevitably change, but right now [June 2021] that’s a very typical profile for an owner of an SME.

Justin Levine:
The disadvantage with something like that is very clear. In a seller’s mind, a business makes a certain profit. And, of course, they’ll be looking at operating profit, not EBITDA. Typically that operating profit is stated before the changes in the balance sheet due to dividends. In other words, they’re not looking at the balance sheet, they’re just looking at the operating profit level. And they’ll assume that they’ve done their mental calculation, spoke to their mates down the pub, and said, “My business is worth operating profit times X,” whatever the number happens to be. “That’s what my business is worth.” But, of course, we have to adjust that number to show what it looks like under new ownership. And if a new owner has got a substitute you, and saying, “Well, you’re running the business. We need a new managing director.” It has to backwards adjust in the real cost of that. So, of course, it can change that operating profit or EBITDA number positively or negatively.

Nick Davies:
I suppose another example, and we see this sometimes, is property costs. Sometimes an owner of an SME might own the underlying property from which the business is operated. It might be held in a pension fund. It might be held personally. It’s not always the company that owns the underlying property asset. For whatever reason, the rent might not be a market rent. It might be higher. It might be lower. It might be designed to be whatever suits the seller or suits the business. Any incoming buyer is going to want an arm’s length market rent to be charged. That’s something which again, is going to have a swing on your adjusted EBITDA, presumably?

Presenting EBITDA objectively

Justin Levine:
I think that’s exactly right. And I think the key messages is, one can never pull the wool over a sophisticated buyer. And, of course, we both deal with buyers that are usually quite large in one form or another, and they will examine this and they’ll come to the same conclusion. So, one is a seller saying, “Listen, the operating profit is X. We don’t pay the rent, because we own the building. We don’t pay ourselves a market rate salary, because we’re paid dividends, but that’s the number.” It doesn’t wash. And that’s why a professional M&A firm / corporate finance firm will advise … I’m sure we, amongst others would say, you have to present it objectively as a buyer would see it. One can show synergy, one can show the potential benefits of a business under new ownership. And I think that’s a right and reasonable thing to do, because, of course, there could be an improvement in that EBITDA under new ownership.

Nick Davies:
Economies of scale on purchase, supply or whatever. You can try and factor those in.

Justin Levine:
And we do do that. We model those numbers. But that, hopefully, explains the adjusted EBITDA number and, that forms one part of the equation of “what’s my business worth?” And then we move nicely over to the multiple.

EBITDA multiples and how they apply to different industries

Nick Davies:
Yes, which people always want to know, what multiple is applicable to my business?

Justin Levine:
There’s a very famous author that came to the conclusion that the reason of life was 42, wasn’t it? I think it was Douglas Adams. Sorry, the meaning of life, not the reason of life.

Nick Davies:
That would be a nice multiple.

Justin Levine:
And it’s the same multiple that when you read accounting textbooks … Typically, you will see the magic number of four or five as being the average multiple. And like all myths, there’s a degree of truth. And the way that I like to try and explain this is to say that there is a bell curve. And most people are familiar with a bell curve. And, of course, one side we’ve got a low multiple number. And the top point, we’ve got an average. And then out here we’ve got a very high multiple. And, the reality is it’s different per industry.

Nick Davies:
Per sector. Yes.

Justin Levine:
It’s common sense in my view. If somebody’s going to buy a business and it delivers a certain cash flow, EBITDA, adjusted EBITDA, a buyer might say, “Listen, in a certain industry, I’m prepared to pay five times that value. Five years’ worth of that number to buy that business.” And it could be that in another type of industry, they could say, “Listen, you’re in a fantastic [position]. You’re just about to discover the cure for cancer. And that drug you’re producing, that pharmaceutical compound, might have a lifetime of 20 years under its IP ownership, and therefore I’m prepared to pay 30 times that EBITDA.” So in other words, different industries command in the market, in real life, different EBITDA multiples.

Third-party reporting of EBITDA

Justin Levine:
One can obtain; there’s various organisations such as Experian, people like Dealsuite, people like at Bureau van Dijk. There are organisations that track…

Nick Davies:
Deal data…

Justin Levine:
Yes deal data. I have to say, one has to treat that with a degree of caution, because of course, typically they’re only tracking deal multiples that are either a) reported, or b) driven by PLCs acquiring smaller companies. Because they have to report those numbers. Private to private, limited company to limited company transactions typically remain unreported.

EBITDA and scalability

Nick Davies:
Unreported, yes. And I suppose that just to give some examples; businesses which are more easily scalable. Those businesses, I’m thinking of IT, technology, telecoms, perhaps where you’ve got a certain piece of technology or an app, which means that your business can be rolled out nationally, can be rolled out potentially internationally, fairly easily based on that technology. That would be an example where a buyer could hopefully be persuaded to use a higher multiple than, say, a more conventional business, which has more traditional routes to growth. And which might be a slower and steadier path where a lower multiple might be appropriate.

Justin Levine:
I think that’s rightly said. There are some ingredients, and perhaps want to touch on in another video to say if you know that you want an exit, and you know you’ve got time on your hands, years, what can you do with your business to make that multiple a higher number? Then building in intellectual property, building in scalability. These are typically things that drive up multiples. But the other thing that is what I call good old-fashioned competition, because if you’re selling a company, there’s two different types of buyer can buy it. In short, there’s a strategic buyer, (a trade buyer), somebody in your industry, a bigger company. And another is a financial buyer. Somebody that’s going to buy that organisation simply for the financial profits your business makes. It could be private equity, high net-worth, family, office, or sole.

Justin Levine:
Typically, in terms of most of the SMEs we’re dealing with, I would argue that a trade buyer, a strategic buyer tends to be where the higher multiples come from. And, of course, the key in selling a company is to create some competition. And just the element of competition itself between rival bidders that want to acquire the business, especially if it’s well-prepared and well-presented, can drive the multiple up. But there’s no doubt that certain industries command certain typical norms in terms of multiples. So you can have as low as three and you can have 20 plus. It depends on what industry you’re in.

Nick Davies:
Fascinating. Thanks, Justin.

Justin Levine:
Thanks, Nick.

Nick Davies:
Talk again.

_ _ _ _ _ _ _ _ _ _ _ _

More from Series 1 of M&A Deconstructed

As part of this in-depth series, other topics discussed include:

  • What are Heads of Terms?
  • Equity Share vs Asset Sale
  • Completion Accounts vs Locked Box
  • What is Due Diligence?

Connect with the M&A experts

Justin Levine, Managing Director, The NonExec Limited M&A Boutique 
Justin leads a boutique exit advisory firm specialising in manufacturing, technology, IT, digital, healthcare, wholesale and distribution markets. With the support of a 15-strong virtual team of analysts and researchers, he helps private business owners with growth and exit strategies. Connect with Justin >

Nick Davies, Partner and Specialist M&A Solicitor, Steele Raymond LLP
Nick acts for a wide range of business clients across various sectors, advising on complex corporate transactions including company sales, purchases and mergers. Nick also advises on mergers, de-mergers and re-organisation. Connect with Nick >

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If you have any questions regarding your business, a business exit, a merger or any other corporate legal query, please contact Nick Davies on 01202 294566 or email [email protected] 

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