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Adjustments to EBITDA revisited

Wagner

Readers of this column know that adjustments to EBITDA are one of my favorite topics. Those same readers also know that the Adjusted EBITDA line on a profit-and-loss statement is a non-GAAP item. (GAAP stands for Generally Accepted Accounting Principles.) Accounting professionals know that the Adjusted EBITDA is something that plays a central role in mergers and acquisitions; indeed, it’s in every single deal we do. So why are accountants so weary of the Adjusted EBITDA figure? It’s because the credits and debits that are used to generate the Adjusted EBITDA figure are subject to negotiation, opinion, and subjective analysis. Yet the Adjusted EBITDA figure is widely used and accepted when a company is valued for acquisition, and it is not controversial to rely on it for that purpose.

Why is the Adjusted EBITDA my favorite M&A topic? Well, our firm works “the sell-side.” We are the seller’s representative in a merger, recapitalization, or acquisition. Any credit to EBITDA is additive to the adjusted EBITDA. And since companies are purchased as a multiple of Adjusted EBITDA—let’s say that multiple is 5X— any $1 added to Adjusted EBITDA is worth $5 on the company valuation.

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Most companies we sell have owners who want to retire. If they retire at the closing of the transaction, and the acquirer won’t have to pay them under new ownership, doesn’t that mean their entire salary and benefits package is a positive credit to EBITDA? If one of the owners who is walking away makes $250,000 all-in, can’t that $250,000 be a positive EBITDA adjustment for the seller? And at a 5X, doesn’t that mean a $1.25 million lift in purchase price? Possibly.

Let’s say the owner who is leaving is the lumber buyer. If he intends to leave, the acquirer will rightfully ask who is going to take his place.

If the seller says, “We are promoting a fellow from estimating to do that job,” then the seller won’t get the full $250,000 credit to the Adjusted EBITDA. The seller will get only a partial credit, which is the difference between what the new owner is paying the new lumber buyer and what the seller was paying himself for that same job. Let’s say the new lumber buyer will be paid $100,000, all-in. (Remember, the seller was $250,000, all-in.) So that $150,000 difference is a valid credit to Adjusted EBITDA. $150,000 X 5 = $750,000 lift in company value.

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But what if the seller who was making $250,000 is staying after the closing and will continue in his old job? Owners often pay themselves more than “fair and customary” salaries for the jobs they do. Let’s say that the “fair and customary” salary under new ownership for a lumber buyer is $100,000; that’s what the old owner (who will become an employee after the deal closes) will get paid. In that case, the difference between $250,000 and $100,000 is a credit to the Adjusted EBITDA line. That $150,000 differential is a valid credit to Adjusted EBITDA.

Adjustments to EBITDA are always the most discussed line item in a profit and loss statement, and there can be some real horse trading that goes on, e. g. “OK, I’ll give you the $100,000 salary for the lumber trader’s compensation, but in exchange, we have to move to fair and customary for your son-in-law in the door shop, because he is clearly making a ‘friends and family’ wage.”

Lastly, when you are tallying up the credits for Adjusted EBITDA, knowing that it could be 5X to your benefit for every dollar you add, don’t go crazy. Don’t add “ash and trash” (items below $5,000), because they will likely be ruled out by the acquirer anyway.

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John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at j.wagner@1stwestma.com

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