In mergers and acquisitions (M&A), sellers and buyers normally base their price calculations on "multiples" of EBITDA, a figure often used by investors to analyze a company's value. EBITDA is extremely important in M&A transactions, and especially so for the determination of the purchase price. However, like all other estimation tools, EBITDA has inherent limitations and dangers.
The term is not formally defined by general accounting standards, rather it is an acronym for "Earnings Before Interest, Taxes, Depreciation and Amortization." While the theory behind multiples based on EBITDA may be sound, in practice reliance on these by sellers and buyers alike is often quite flawed. Additionally, the use of EBITDA in estimating value in small or family-owned business transactions creates difficulties in the negotiation process because of the limited availability and quality of financial statement information.
When and why does EBITDA become a problem?
EBITDA is used in M&A transactions, in both binding and non-binding offers, in order to determine the purchase price that will be paid. In non-binding offers, the use of EBITDA does not present a problem since the purchase price included is not enforceable against the parties in an eventual disagreement. However, in binding offers, EBITDA can be problematic for either side of the transaction when the EBITDA of the company is higher or lower than expected. So for buyers and sellers negotiating a binding offer, it is important to understand the limitations to EBITDA before using it or EBITDA multiples for estimating value or pricing a business.
As mentioned, EBITDA is not a measure of financial performance calculated in accordance with generally accepted accounting principles (GAAP) and therefore, there is no general consensus as to its official calculation which may vary according to the accounting police of each company. Despite being a widely accepted measure of earnings capacity, it can therefore easily be manipulated by adjusting a company's revenue and expenses through:
- company accounting policies, such as revenue recognition, accounts receivable, reserves, etc.;
- the EBITDA calculation's lack of attention to changes in working capital and investing cash flows, such as capital expenditures, proceeds from asset sales, and cash expenses for liabilities already accrued, such as employees' vacation time accrued; and
- adjustments to earnings, in order to adjust for excess compensation, discretionary expenses and others.
The bottom line here is that the results of the EBITDA calculation may vary significantly from different auditing firms what may bring a claim between buyer and seller. It is thus important to understand EBITDA's limitations before using it to value and price a business.
How to mitigate the problem?
Even though EBITDA is a widely accepted measure of earnings capacity, as already mentioned it is not a standard measurement but rather a concept. As such, EBITDA must be defined for each specific case, taking into consideration the specifics of the business involved in the M&A transaction.
In addition, one should bear in mind that computing EBITDA for valuation purposes requires that we perform a comprehensive analysis of historical operations, as well as future projections. At the end of the day, in trying to determine what the target business will do in the future, it is necessary to use historical performance as a benchmark, but also to make sure that there have not been any major changes that would result in future financial performance differing from past trends. For example, technological changes in the industry, major changes in significant drivers of the business (such as the loss of a major customer or of a key manager), and many other factors, could each result in historical results being different from future results.
When looking at historical financial statements, business analysts look to normalize results to recurring predictable numbers free of anomalies. But for the EBITDA calculation to hold any water, it is imperative that any factor that is not recurring be added back correctly into the EBITDA calculation. When buying or selling a business, particularly a small or family business, some of the non-recurring items listed below must be watched out for in order to compute EBITDA at the moment of pricing:
- Revenues or expenses not conducted at "arm's length": Family businesses often transact with related parties, such as major shareholders, at prices different from those which would be arrived at in an "arm's length" transaction. Some companies do not own the facilities they occupy, but rather continuously rent them from the shareholders or other companies owned by such shareholders, where the rent may be significantly different from that of a property rented from an independent landlord. These kind of transactions should be adjusted or "normalized" to their fair market value so as to avoid biasing the EBITDA calculation towards prices that are not attainable in the future.
- Revenues or expenses generated by redundant assets: Redundant assets are added to enterprise value after the multiple has been applied.
- Owners and key employees' salaries: Salaries of the business owners and their relatives often differ from the salary that would normally be drawn by a completely independent manager. In Brazil, in particular, managers and key employees are frequently paid through the use of "pessoas júridicas," separate legal entities often used by service providers, facilitating this distortion. Any dividends and service providers' payments need to be isolated and added back in order to calculate the purchase price using the EBITDA.
- Start-up and wind-down: Because the earnings figure provides a snapshot, if a new business line has been started or an old line wound down within the historical results being analyzed, sunk start-up or exit costs may affect the calculation, as will revenues collected from a successful exit. These costs or revenues should be added back to normalize the EBITDA calculation because they will no longer be incurred or enjoyed going forward.
Other methodologies used in M&A
EBITDA requires a calculation methodology for avoiding the problems related to measuring earnings. (i.e. draft of a specific formula for such transaction or use a different common techniques for valuation). The most common techniques are:
- Comparable publicly traded companies ("Public Comps"): Analysis indicates how the stock markets are valuing companies similar to the target company.
- Precedent comparable transactions ("Transaction Comps"): Analysis indicates the valuations used in prior M&A transactions in the same industry as that of the target company.
- Sum-of-the-parts: If a target has more than one lines of business, the financial advisor may value each business separately. Therefore, each "part" might have its own Public Comps, Transaction comps, and the total value is the sum of the parts.
- Other: Depending on the unique characteristics of the transaction, financial advisors will perform a number of other analyses to arrive at a fair valuation, such as Leveraged Buyout ("LBO") Analysis, Historical Exchange Ratio Analysis, and other techniques.
In view of the above exposed, it is important to highlight that depending on the features of each transaction it may be better to examine methods other than EBITDA that can be more skilled for specific cases. In this sense, for the avoidance of transactions damages, EBITDA shall not be broadcast without a higher level of care.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.