Setting pricing still starts with normalizing EBITDA.
Because the financial matters of most privately owned companies are typically managed to minimize tax liabilities rather than to provide an accurate picture of the seller’s true profitability, buyers and sellers have to work together to normalize, or adjust, the selling company’s historical, current, and projected earnings before income, taxes, depreciation, and amortization (EBITDA) to account for any excessive or one-time operating expenses.
Realistic buyers will agree to add back operating expenses that will not continue under their ownership post-closing, such as excessive owner compensation or the costs of a major onetime lawsuit settlement, into their pricing model. The buyer will also subtract out any replacement costs they believe will be needed to operate the business under their ownership. That calculated amount becomes the baseline for the purchase price calculation.
Buyers and sellers calculate common adjustment categories differently.
The following lists the most common adjustment categories and how buyers and sellers approach recasting them.
Owner Compensation – The owner’s compensation in closely-held companies is arguably the most carefully scrutinized expense category when attempting to normalize EBITDA. The buyer will review the base salary, bonus amounts, and any perks and benefits that is paid to each owner of the selling business to determine if they are being paid at a fair market rate for the position(s) held and for the size of the business that is being sold. Replacement salary adjustments will be made to account for excessive levels of officer compensation. If the owner is not providing any definable services for the selling company, then as much as 100% of the owner’s total compensation will be added back to EBITDA.
Rent Expense – If the building is owned by the selling company’s shareholders and rented back to the company, the rent expense may need to be normalized to reflect fair-market rates of comparable office space in that region. In instances where the owner of the building is not charging a rent expense to the business, the fair market value of rent is deducted from the operating income. If the company is paying rent that is more than the fair market value, the excess amount is added back to operating income.
Salaried Family Members – In cases where the owner’s family members are on the payroll, adjustments may need to be made to reflect fair-market compensation for services rendered.
Extraordinary or One-Time Expenses – Adjustments may be necessary to account for the costs of any one-time events (relocation expenses for example) or purchases that are not of regular operating nature (settlement of a major lawsuit).
Treatment of any stimulus PPP small business loans – Starting in Q3 of 2020, the letter C was added to the end of EBITDA to account for any temporary revenue reductions and one-time (non-recurring) expenses associated with the Coronavirus pandemic. These EBITDAC amounts typically included the following:
- Any temporary loss of revenues attributed to client and/or governmental mandates to temporarily cease collection activities either into certain regions or toward a type of client account (student loans for example);
- All direct, non-recurring expenses associated with implementing work from home capabilities; and
- Treatment of any stimulus PPP small business loans.
Most buyers look back multiple years to track the sustainability of a seller’s financial performance. That’s why it is critical to adjust properly for the impact of government stimulus and consumer behavior on a business.
Net Debt and Working Capital Adjustment
Transactions involving ARM companies typically occur on a “cash-free, debt-free” basis. A net debt and working capital calculation is applied to the selling company’s enterprise value to provide the acquirer with a clean balance sheet and sufficient working capital. Net debt and working capital for transaction purposes is the total value of current assets, less all liabilities, and a mutually agreed to number of days of operating expenses. Often times, the buyer will look back over several years to determine if any significant changes have taken place on the balance sheet even though the ultimate effect is usually derived from either the most current year-end financial statement or a trailing twelve- month timeframe.
Kaulkin Ginsberg Company is uniquely qualified to advise buyers and sellers of ARM business. Email us at firstname.lastname@example.org to confidentially discuss your specific needs.
About Kaulkin Ginsberg Company
Since 1991, Kaulkin Ginsberg Company has provided critical strategic advice to the ARM industry. Our client-centric approach covers almost every stage of a company’s life cycle and enables us to maintain longstanding relationships as trusted advisors. We provide mergers and acquisition advisory, strategic consulting, and valuation services.