Avoiding the EBITDA Multiple Bait and Switch

By: Brandon Bisack

When considering the valuation of your company, discussions often revolve around EBITDA multiples. Business owners, investors, and bankers throw around terms like “7x,” "10x" or "15x" for company valuations. While multiples are undeniably crucial in the valuation discourse, business owners must not overlook a fundamental question: "What EBITDA is that multiple being applied to?"

EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization) is a common metric used to estimate a company’s operating cash flow. Despite what seems to be a simple equation, understanding the differences between transactional vs. accounting/reported EBITDA is vital for maximizing the value of your business and positioning the business for growth and success.

The accounting/reported EBITDA provided by your accountant is a historical look at a company’s performance. It provides a starting point for a business valuation, but it does not incorporate a company’s performance outlook. That is where an experienced investment banker comes into the picture. Companies are continually evolving and responding to industry dynamics. When determining transactional EBITDA, an investment banker incorporates factors such as a company’s strategy, recent investments, strength of leadership talent and changes in key management, new service or product expansions, changing cost structure, market trends and how all may affect EBITDA. It is from this forward-looking transactional EBITDA that business owners want to sell their business, not the typically lower accounting/reported EBITDA that buyers prefer.

Every dollar of transactional EBITDA that your investment banker confirms and can support through a buyer’s due diligence results in the seller receiving an EBITDA multiple of that dollar! An investment banker’s thorough forensic analysis of your business may help identify EBITDA enhancements by:

  • Uncovering non-recurring/discretionary expenses.
  • Identifying expenses that may not continue post-acquisition (i.e. synergies).
  • Addressing unique situations where the business may have made a material change in cost structure mid-year.
  • Annualizing new vendor contracts at lower annual costs.
  • Recognizing the impact of a new revenue relationship to anticipate how the new contract may mature and potentially strengthen the company's financial position.

An investment banker’s ability to identify EBITDA enhancements and to benchmark operating margins enables a business owner to maximize its transactional EBITDA and enhance value. For instance, through collaboration with an investment banker well versed in the lower middle market, the business owner in our example managed to boost revenue by $200,000, which, at a static 9x multiple, increases the value of the company by $1.8 million. In the example below, negotiations and strategic processes further contributed to potential increases in the EBITDA multiple by 1x-2x. An increase in the multiple from 9x to 11x, along with analysis showing increased revenue of $200,000 and reduced expenses of $375,000, would result in a valuation increase of $12.3 million.

MidCap Advisors’ quality of earnings process for business owners considering a sale ensures that the EBITDA multiple a business owner receives aligns with the maximum EBITDA of the entity. While business owners understandably focus on the received multiple and its comparison to competitors, it is essential to recognize that this assessment is only one side of the equation. A comprehensive understanding of the underlying EBITDA and margin dynamics is equally crucial for making informed decisions and optimizing deal outcomes.