In the world of M&A, different valuation methods are used. In the PEO industry, the most common valuation method is a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA). This article will explain the importance of an EBITDA add back and illustrate how to properly frame them so that the buyer clearly understands the impact of add backs.
EBITDA Add back
An EBITDA add back is a justifiable return of profit to the organization based on changes within the company pre or post acquisition that is not seen in historic financials. We have found that the easiest way to explain add backs are through an example.
If a PEO had an EBITDA of $5MM for 2016, the seller often mistakenly bases the estimated multiples for valuation off this number. This may prove a costly mistake as additional profit may flow through to the buyer once the acquisition is made. Some of this profit is realized through cost synergies, to the benefit of the buyer. Though some of this new profit flow can be justified via an EBITDA add back which will benefit the seller. For example, if an owner paid himself $1MM annually in salary and planned on exiting the organization at the time of sale, the $1MM would be viewed as a legitimate EBITDA add back. Any expense that could be justifiably eliminated at or around the time of transaction may be proposed as an EBITDA add back.
While EBITDA add backs are commonplace for those in M&A fields, business owners may not realize this important step, especially if this is their first sale. EBITDA add backs are important for two major reasons.
- EBITDA add backs often illustrate the true profitability of an organization.
- If the true profitability is higher than unaltered EBITDA, the seller will realize an increase in valuation.
Sample Addback Document
Below is a simple example of an EBITDA add back document. While this documents can get much more detailed in nature, the below example will give you an idea of how this process works.
|$ 1,000,000.00||Ownership Salary Elimination||Immediate||Owner has not been involved in day to day operations and is not material in moving the business forward|
|$ 30,000.00||Private Jet Travel||Immediate||Owner was the only person using the private jet|
|$ 25,000.00||Payroll Software||0 – 3 months||Company upgraded payroll systems for lesser charge. Implementation will be completed within first 3 months post transaction|
|$ 250,000.00||Sales Force||3-6 months||Company has planned to terminate underperforming sales reps. The bottom 10% of the sales force accounts for less than 5% of new business production.|
|$ 1,305,000.00||EBITDA Add backs|
EBITDA add backs are not immediately accepted by the buyer. They are scrutinized for the validity and impact on the organization. It is the buyer’s job to analyze the EBITDA add back. It is the seller’s job to justify the add back. Often portions of add backs are accepted and portions are discarded during the negotiation and due diligence processes.
When illustrating potential add backs, the seller should be sure to include the category, amount, timing, description and rationale of the add back. Do not confuse description with rationale. The description illustrates the move the company is looking to make or has recently made. The rationale explains the go forward impact to the organization from both the short and long term perspective. For instance, if a seller reduces staff by 15% right before a sale, the timing is immediate and the EBITDA increases. However, the buyer will need to know the rationale for the move and the long term affects.
Add backs affect the valuation much greater than most expect. If we use the aforementioned example with the beginning EBITDA of $5MM and adjusted EBITDA of $6.305MM and assume the buyer will pay a 7X multiple, the difference in purchase price rose from $35MM to $44.135MM. This equates to an increase of $9.135MM in purchase price. Even a small justified add back of $100K at a 7X would equate to $700K in additional purchase price (valuation).
Contractual Realization of add backs
Whether or not the owner is to remain with the company post acquisition, add backs may be contracted over a period of time. For example, if the timing of an add back shows a realization within 12 months, the purchase agreement can reflect an earn-out associated with achieving the proposed add back within a specified time frame. This format provides a bridge for add backs that the seller feels confident in achieving whereas the buyer may be more skeptical about the realization of the add back.
EBITDA add backs are an important part of the M&A process and should be an area of focus. Legitimacy of add backs are essential as each add back will be thoroughly reviewed by the buying party. For more information on the M&A process within the PEO space, you may contact Business Resource Center, Inc. at www.biz-rc.com.
Author: Rob Comeau is the CEO of Business Resource Center, Inc. BRCI is a management consulting company that works with PEO companies, investors, investment bankers and private equity firms. For more information on BRCI, please visit them on the web at www.biz-rc.com.