When valuing a lower middle-market business, buyers typically focus on Adjusted EBITDA as their primary metric. Many sellers mistakenly believe that net income or balance sheet asset values drive valuations, but this is rarely the case. Unless unusual circumstances arise, buyers will start with reported EBITDA, then make normalizing adjustments (or “addbacks”) to arrive at Adjusted EBITDA. This metric is key to determining the business's value, as buyers typically apply a market multiple (i.e. 3x, 4x, 5x, etc.) to Adjusted EBITDA when determining a purchase price. 

While it sounds straightforward, sellers must understand this calculation as it directly impacts their business’s valuation. Additionally, Adjusted EBITDA is often heavily reviewed and negotiated during a transaction. 

What Is EBITDA? 

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It can be easily calculated from financial statements using this formula: 

Operating Income + Depreciation + Amortization 

Operating income can be found on the income statement, typically preceding any other income or expense such as interest income, interest expense, gain (loss) on sales of assets, etc. Depreciation and amortization expenses are typically recorded in the income statement as operating expenses. It's essential to note that operating income differs from revenue or net income. Operating income is calculated as follows: 

Revenue – COGS – Operating Expenses 

By excluding taxes, interest, and other non-operating items, we get a clearer picture of the company’s true operational performance. Adding back depreciation and amortization, which are non-cash expenses, gives us EBITDA, which serves as a proxy for a company’s operating cash earnings. EBITDA is not a perfect metric, however it is the most widely used valuation tool we see in the M&A space.  

Understanding Adjusted EBITDA 

Once reported EBITDA is calculated, buyers will apply normalizing adjustments to arrive at Adjusted EBITDA. Normalizing adjustments include one-time, non-recurring expenses that currently appear on the income statement but will likely not continue post-transaction. If you are considering selling a business, we advise sellers to prepare an Adjusted EBITDA schedule prior to bringing the business to market. The seller should be heavily involved in determining any one-time, non-recurring expenses to ensure all potential addbacks are considered.

Once Adjusted EBITDA is calculated, M&A advisors can provide sellers with a reasonable valuation range prior to a potential sale. 

Common EBITDA Adjustments 

Below are the most common adjustments made to EBITDA during a transaction: 

Owner Salary & Compensation

An addback for any excess owner compensation is appropriate if it exceeds the going market rate for the owner’s position. Owner compensation (at market) is typically not considered an addback when the owner is actively involved in the day-to-day business and is essential to continuing business operations. Sellers should also include addbacks for any family or related parties who receive a salary but are not actively involved in the day-to-day business.  

Other Owner-Related Expenses 

Personal expenses that will cease post-transaction, such as personal vehicles (fuel, repairs, etc.), home expenses (mortgage, home improvement, repairs, etc., insurance (home, vehicles, life, health, etc.), meals, travel, or club memberships, can be included as an addback to EBITDA. 

Rent Expenses 

If the seller owns the company’s real estate through a separate legal entity and charges above- or below-market rent, adjustments should be made to reflect true market rent. 

Professional Fees

Any professional fees, such as accounting, legal, or M&A, related to the potential sale of the business can be included as an addback to EBITDA.  

Gaps in the Management Team

If the business relies heavily on the owner-operator, a prospective buyer will need to consider hiring new executives to fill any open roles. Any additional costs result in negative adjustments to EBITDA. 

Litigation Expenses

One-time or non-recurring legal expenses can be added back to EBITDA. These expenses could be related to a rare or unusual legal case the Company is currently involved in. However, ongoing legal costs are typically not included as an addback to EBITDA. 

The Importance of Addbacks and Negative Adjustments 

Addbacks directly influence a business’s valuation by increasing Adjusted EBITDA. For example, if a one-time marketing expenditure of $50,000 is added back, and the transaction EBITDA multiple is 5x, the transaction value or purchase price increases by $250,000. 

On the flip side, negative adjustments reduce EBITDA. As mentioned above, negative adjustments can include hiring expenses for any new executives or under-market rent expenses. Although sellers may hesitate to present negative adjustments, being upfront with the adjustments can enhance credibility with buyers and lead to smoother transaction negotiations. 

Navigating EBITDA Adjustments with Lutz 

Accurately calculating and presenting Adjusted EBITDA is crucial for maximizing your business's value in a transaction. If you are considering selling a business, we advise sellers to prepare an Adjusted EBITDA schedule prior to bringing the business to market. Sellers should work with their M&A advisor to discuss any adjustments included in the Adjusted EBITDA schedule to ensure the adjustments appear reasonable.  

We understand that some business owners receive interest from prospective buyers prior to speaking with an M&A advisor. It is still essential for sellers engaged in a sales discussion outside of a full sell-side marketing process to address Adjusted EBITDA early in transaction discussions. This ensures all relevant adjustments are considered before a transaction moves forward.

At Lutz, our experienced team offers a wide range of M&A services to guide you through this complex process. Our team can assist sellers in preparing an Adjusted EBITDA schedule and ensure that all relevant adjustments are identified and properly presented to potential buyers. Please contact us with any questions or for additional information on our services.