As featured in our Q1 2013 Capital Ideas Newsletter. An article by Doug Nix, Managing Director of our Toronto West, Ontario office.
In today’s M&A environment, an EBITDA multiple is by far the most common methodology employed to value a privately owned business. It is used because of its simplicity and ease of calculation. In its basic form, the formula is:
EBITDA Multiple x Adjusted EBITDA = Debt Free Enterprise Value
These days, almost every valuation discussion with business owners and acquirers seems to focus entirely on the EBITDA multiple portion of the formula. This is understandable because there is widespread reporting of EBITDA multiples - its quarterly trends, averages by industry, mid points based on transaction size, etc.
But Mark Twain’s words “There are 3 kinds of lies – lies, damn lies and statistics” ring very true in using Reported EBITDA multiples.
A recent review comparing published EBITDA multiples to the actual multiples that were used to calculate transaction values show a marked gap between these multiples. Not surprisingly, in almost every case the published multiples are higher. The question, in the words of Boston Legal’s Alan Shore, is “Now why is that?”
The starting point is to understand how EBITDA multiples are calculated. Reporting agencies generally use the following formula to calculate Reported EBITDA Multiples:
Reported Transaction Value / Reported EBITDA = Reported EBITDA Multiple
Seems simple enough, but the devil is in the details. There are 3 factors that distort the calculation of the EBITDA multiple in this formula.
1. Treatment of the transaction structure in the calculation of the transaction value. For example; if earnouts or other contingent payouts are included in the transaction value before they are earned, the transaction value is inflated. If the earnout is based on achieving increased earnings, then reported EBITDA should (but never do) reflect the increased earnings used to calculate the earnout, otherwise the multiple is inflated.
2. Balance Sheet Adjustments. A common purchase price adjustment relates to working capital surplus or deficit. These adjustments are not based on earnings, yet are always included in reported transaction values.
3. Inconsistent Calculation of Reported EBITDA. Every privately held business requires “normalizing” adjustments in order to calculate maintainable earnings. Often “Reported EBITDA” is not normalized EBITDA. In other cases, where the business owner and the acquirer disagree on the amount of the normalizing adjustments, there is a negotiation to change the EBITDA multiple. Not reporting earnings after these adjustments distorts the reported EBITDA multiple.
We recently sold a business through a strong competitive bidding process. The price was determined as follows:
- The EBITDA multiple was 5.0 times Trailing Twelve Months (TTM) normalized EBITDA, plus
- An earnout of $2.5 million if EBITDA increases by $500,000 in 1 year, plus
- A working capital adjustment
[(1) $500,000 increase in EBITDA by end of year 1 ($2,500,000 - $2,000,000) x 5.0 (multiple) = $2,500,000 earnout payment]
Using the same information, reporting agencies would have calculated the Reported EBITDA multiple as follows:
The same transaction, but 2 very different EBITDA multiples – the negotiated EBITDA multiple used to calculate the actual purchase price was 5.0 whereas the Reported EBITDA multiple was 7.78.
So - what was the actual EBITDA multiple for this transaction? Clearly, the actual multiple of 5.0 times is the answer, however, this number is never reported and herein lays the EBITDA Multiple Trap.
The EBITDA Multiple Trap
What if the business owners had used published EBITDA multiples to establish their valuation expectations? They would have been significantly over market.
[(1) $500,000 increase in EBITDA by end of year 1 ($2,500,000 - $2,000,000) x 7.78 (multiple) = $3,890,000 earnout payment]
There is a striking and vast gap between the actual market value ($14,000,000) and the Expected Market Value ($20,950,000). One can easily see why many business owners have experienced great disappointment in buyers’ assessment of the value of their business and many “market value” offers have been rejected because owners and their inexperienced advisors have used Reported EBITDA multiples.
The best approach to using the EBITDA multiple method of valuation is:
- to be very cautious with any reported multiple and
- talk to someone who has substantial experience with actual business sales before driving your “Expected Transaction Value” stake in the ground.