0:00

EBITDA is a phrase you often hear when talking about size,

0:02

profitability and valuation of a

0:05

company. But it actually isn't a

0:05

technical accounting term.

0:09

Probably most famous and one of

0:09

the big reasons business owners

0:12

really care about EBITDA, is the

0:12

EBITDA multiple, that is often

0:16

used to approximate the expected

0:16

valuation of a company. It

0:19

sounds simple, but like most

0:19

things, well, it just isn't. On

0:24

today's episode, we'll talk

0:24

about what exactly EBITDA is,

0:28

why it's used, especially since

0:28

it isn't a formal accounting

0:31

term, the rationale and

0:31

methodology for adjusted EBITDA

0:35

and the perspective of buyers

0:35

and investors.

0:43

Welcome to Right in the Middle

0:43

Market, a podcast about

0:46

pragmatic perspectives on

0:46

running, growing and selling

0:49

your business. We talk about the

0:49

challenges, decisions, and most

0:52

importantly, the actions

0:52

business owners can take to

0:55

create long term value in their companies. Welcome to Right in the Middle

1:01

Market. I'm Stephanie Chambliss

1:04

Gaffin. And I'm here today with

1:04

my co host Mark Gaffin. When

1:09

people are talking about selling

1:09

their company, or how well their

1:12

company is doing, or the size of

1:12

their company, they often talk

1:16

about EBITDA. Except when they

1:16

don't and then they talk about,

1:20

maybe they talk about profit or

1:20

bottom line or operating margin

1:25

or net profit. And for those who

1:25

are in finance, the difference

1:29

between all of these different

1:29

phrases is intuitive. For those

1:32

of us who maybe didn't grow up

1:32

in finance, it is not always as

1:37

obvious. And what we often find

1:37

is that people are using these

1:41

phrases interchangeably when in

1:41

fact, there are distinct

1:44

differences. On today's episode,

1:44

we want to dive into EBITDA

1:49

specifically, because it is such

1:49

an important measure in talking

1:54

about companies and particularly

1:54

when we start to think about

1:57

transactions and valuation. So

1:57

we want to understand what is

2:01

EBITDA? Put it in context of

2:01

some of these other metrics, and

2:06

then be able to talk about some

2:06

of the different ways that

2:09

EBITDA is used. So with that

2:09

Mark, as the person who does

2:15

have the finance background, and

2:15

for whom this is generally

2:18

intuitive. Let's start with what

2:18

exactly is EBITDA?

2:23

So I think, maybe

2:23

we'll start even just looking at

2:26

the P&L just to orient ourselves

2:26

there, and then move to EBITDA,

2:31

because EBITDA is not a GAAP

2:31

term, that's a general-

2:34

Generally

2:34

accepted accounting principles.

2:36

Exactly.

2:37

I love it, for those keeping score at home that score one for

2:39

Stephanie.

2:41

It's Friday. So

2:41

anyways, EBITDA is not a GAAP

2:44

term, but let's go back to the

2:44

financial state for just a

2:47

second, you know, you go from

2:47

revenue, you go down to, through

2:51

all the direct costs that

2:51

actually, regrettably be used a

2:54

manufacturing firm. All the

2:54

direct labor, direct materials

2:58

in some overhead allocations, it

2:58

gets you to a gross profit. And

3:02

I think most people are familiar

3:02

with that term. And that's

3:05

really important when you think

3:05

about understanding the

3:07

operating of the business. So,

3:07

as a customer, if you will, of

3:12

that data, that's still very,

3:12

very important to me. And then

3:15

you have all the SG&A that comes

3:15

out of the firm, and there's

3:18

different people treat this

3:18

differently. Some people have

3:20

interest in here, some people

3:20

have depreciation in here, but

3:23

all this selling general and

3:23

administrative expenses flow out

3:28

of that, and then it gets you to

3:28

operating profit. So that kind

3:31

of gets you to how are we doing

3:31

after, are we paying all of our

3:34

bills? So if you have operating

3:34

profit, depending on whether

3:39

there are a certain line items

3:39

taken out of there. Operating

3:42

profit could be very, very close

3:42

approximation to EBITDA.

3:45

Operating profit, then if you

3:45

take depreciation amortization,

3:49

which are non cash charges, and

3:49

you take taxes, and you take

3:53

interest expense out of there,

3:53

and then you get down to, and

3:56

there's probably some other

3:56

income items, but that gets you

3:58

principally down to net income.

3:58

What we are trying to do with

4:02

EBITDA in the finance world,

4:02

right, we're trying to find a

4:05

shortcut that gets us to a

4:05

concept, really which is

4:09

operating free cash flow to the

4:09

firm. That's the important part.

4:12

We'll talk about that in

4:12

valuation. But that's really

4:15

important to us is what is the

4:15

earnings power of this company?

4:19

How much cash can it earn, to

4:19

pay bills, to pay capital

4:24

providers? So whether that's

4:24

debt or equity capital

4:27

providers. So EBITDA is, as we

4:27

said, not a GAAP term, but it

4:32

approximates operating profit

4:32

adjusted for things like if

4:39

interest and depreciation and

4:39

amortization were taken out

4:42

before you got to the operating

4:42

profit, then we adjust to make

4:45

sure that's added back.

4:46

And we're adding those things back because those are non cash

4:48

items, right?

4:52

Depreciation,

4:52

amortization, certainly are.

4:54

Taxes would be cash. There

4:54

probably would be two components

4:58

to the cash, there would be a

4:58

cash component at the tax

5:01

expense and then there will be a

5:01

non cash component. And that has

5:04

to do with differences in your

5:04

depreciation, this gets

5:07

technical between book and tax

5:07

balances. And then interest is

5:14

almost certainly 90% cash item.

5:14

There may be some fees and

5:21

things like that, that are

5:21

amortized into that. But yeah,

5:24

so depreciation, amortization

5:24

are non-cash, but taxes and

5:31

interest would be cash. But what

5:31

we're trying to do is get to

5:35

what's the cash flow, before we

5:35

take into consideration, any of

5:39

the financing of the firm. So

5:39

how you finance the firm has a

5:44

lot of impact on whether or not

5:44

you have interest expense, and

5:48

what the tax consequences are

5:48

because there would be a tax

5:51

shield to the interest expense.

5:53

So

5:53

if you will, that's a way that I

5:56

guess, I would use the phrase

5:56

maybe that we're normalizing so

5:59

that the EBITDA, between if I'm

5:59

trying to compare EBITDA, I have

6:02

two different companies, than

6:02

they should be more comparable,

6:06

because we've taken out the

6:06

impact of different sorts of

6:09

financing structures. And we've

6:09

also taken out the impact of

6:13

taxation. If, for example, one

6:13

company is located in a state

6:17

with higher taxes than another.

6:19

Yes, I think that's

6:19

a fair representation. I think,

6:23

what happens is because EBITDA

6:23

is relatively easy to calculate

6:27

from the P&L, and that may be

6:27

what you have from a teaser, or

6:33

it's in the teaser, you know, a

6:33

one page marketing memorandum.

6:36

People start to start there. At

6:36

the end of the day finance folks

6:40

really don't, we don't buy

6:40

companies out of just EBITDA, we

6:44

have a big model that goes

6:44

through all the different uses

6:48

and sources of cash to get to

6:48

what is free cash flow to the

6:51

firm. That's actually what we

6:51

are trying to get to because

6:54

that is ultimately what will

6:54

trigger how much can I buy this

6:59

company for? Or how much can I

6:59

safely invest in this company?

7:02

Coming back though, you will see

7:02

things like loan covenants that

7:07

will be based on EBITDA or, and

7:07

I'm sure we're gonna talk about

7:11

this, adjusted EBITDA which is

7:11

actually even more interesting.

7:15

Yes, we'll certainly get to adjusted EBITDA a little bit later in the

7:16

episode. But I want to come back

7:19

to something you were just

7:19

talking about, to say that

7:22

EBITDA is ultimately not what

7:22

the finance folks will use. I

7:26

think you started to touch on

7:26

this, but then, why do we all

7:30

use EBITDA? Why is it so common?

7:33

I think like

7:33

anything else, it's a shortcut,

7:35

right? I think if you go back to

7:35

our, we always use a housing

7:40

analysis, you know, what is the

7:40

cost per square foot? Right, but

7:43

two houses can be significantly

7:43

different. And so their cost per

7:46

square foot, or the price per

7:46

square foot could be very, very

7:49

different. I think the EBITDA

7:49

you know, EBITDA, than an EBITDA

7:54

margin gives you an idea, right?

7:54

You're like, "Look, plus minus,

7:58

when it all shakes out, you're

7:58

paying eight to nine times

8:02

EBITDA in that in that world."

8:02

But no, one's just gonna say,

8:05

just tell me what your EBITDA

8:05

is, and I'll sign off on it at

8:09

times nine, that's what I'll pay

8:09

for it. You actually have to go

8:11

in and find out what is the

8:11

amount that has to be invested

8:15

in capital expenditures, how

8:15

much has to be invested in

8:17

working capital as you grow?

8:17

Those are all those elements

8:20

that will come into play, when

8:20

you continually figure out what

8:22

free cash flow to the firm is.

8:22

That's the number that I use

8:25

when I'm trying to discount to

8:25

get to like a DCF analysis.

8:30

Right?

8:30

So exactly what I was thinking.

8:33

So discounted cash flow, or DCF

8:33

analysis is one of the

8:38

methodologies that's commonly

8:38

used in valuation. And again,

8:41

we'll have a whole episode

8:41

talking about valuation. But

8:44

that would make sense then, if

8:44

EBITDA is a shortcut that gets

8:48

us to something approximating

8:48

free cash flow and ultimately,

8:52

we want to be able to do the

8:52

valuation on a multiple of free

8:56

cash flow, or just kind of cash

8:56

flow analysis, than EBITDA

9:00

sounds like it's easier to get

9:00

to, there's at least, if not

9:03

GAAP principles, relatively

9:03

accepted ways to get there. So

9:07

that everybody has a shorthand

9:07

to be able to say, "Alright,

9:10

about what would this company

9:10

have on a cash flow basis?" And

9:15

then be able to translate that to valuation.

9:17

Yeah, and I think

9:17

we'll cover this, I think more

9:19

technically, when we get to the

9:19

valuation arc, but two other

9:23

areas of how you value a

9:23

company's relative valuation,

9:27

technology techniques, and one

9:27

would be looking at public

9:30

comps. So if you're looking at

9:30

certain company, you could go

9:33

look at other companies that are

9:33

trading in the public market,

9:35

you can get on

9:35

wallstreetjournal.com, cap IQ,

9:39

any number of different

9:39

platforms to figure out how are

9:42

they trading? You can get to

9:42

EBITDA, people report that

9:45

there, how are they trading?

9:45

What's their enterprise value to

9:48

EBITDA? It will give you some

9:48

guidance to what you might want

9:51

to pay for that specific asset.

9:51

You know, it's not gonna be

9:54

directly comparable, but it

9:54

gives you some idea. And then if

9:57

you look at other deals that

9:57

have gotten done in the world,

10:00

if you're a private equity firm

10:00

that's done some, or if you look

10:03

on a Pitch Book or something

10:03

like that, that covers middle

10:07

market deals-

10:08

Pitch Book for those who may not be familiar with it, is a great

10:09

data source for transaction

10:16

information.

10:17

Right, as in GF

10:17

data and Capital IQ, a number of

10:21

these in Pitch Book is one that

10:21

we're we're very fond of here.

10:25

You go out and look at other people that have done deals, and you can sometimes back into or

10:27

sometimes explicitly, we'll see

10:31

the times EBITDA, what you don't

10:31

know, again, not to keep

10:34

teasing, adjusted EBITDA, that's

10:34

actually the part that got done,

10:37

because there may be add ons. So

10:37

if I'm looking at my adjusted

10:40

EBITDA and comparing it to the

10:40

EBITDA that's posted in the Wall

10:43

Street Journal, there's probably

10:43

some differences in how those

10:47

two were constructed. So it's

10:47

good guidance. And that's why I

10:51

use ranges all the time when I'm

10:51

doing enterprise value. I don't

10:54

do a decimal point precision,

10:54

because you can't consider all

10:58

the differences between those two.

11:00

Okay,

11:00

fine. You keep teasing about

11:02

adjusted EBITDA, so let's go

11:02

there next. When we talk about

11:06

adjusted EBITDA, so I think it

11:06

would make sense to first talk

11:11

about, what- before we get to

11:11

what exactly is adjusted EBITDA

11:16

and how do we do it, let's start

11:16

with why? And I'm guessing

11:20

people have heard the phrase

11:20

have an adjusted EBITDA, but why

11:25

do we want to do adjustments to

11:25

EBITDA?

11:28

So really, there's,

11:28

in any given company, certainly

11:32

companies in the lower end of

11:32

the middle market, maybe what we

11:34

call first time institutional

11:34

money into a company, they've

11:40

run it their way, which is fine,

11:40

right? But there may be a number

11:46

of different things, expenses,

11:46

there may be certain special

11:49

idiosyncratic treatment of

11:49

things in their P&L, and what

11:53

you're trying to do is adjust

11:53

for one time, or different

11:57

variances for market so that you

11:57

actually get to- if I bought the

12:02

company and had it tomorrow,

12:02

what would he about EBITDA truly

12:05

be?

12:07

So

12:07

alright, so that's helpful. And

12:09

I want to remember to go back to

12:09

how we talked about adjusting

12:13

EBITDA after a transaction as

12:13

well. But right now, let's just

12:16

stay on the, if you will, the

12:16

sell side or, or for an ongoing

12:20

concern. So EBITDA is, again

12:20

taking out some of those things

12:25

that are atypical or abnormal

12:25

expenses, right?

12:29

Yes, yeah, I don't

12:29

want to make it sound like it's

12:33

a bad thing. But the abnormal

12:33

meaning, it's not typical in the

12:37

industry, it may be specific to

12:37

that company that we're just

12:40

going to add back. And let me

12:40

give you a real quick example.

12:43

If I were the CEO, or you were

12:43

the CEO of the company, you

12:46

might pay yourself $1 a year.

12:46

But if I'm buying the company,

12:50

I'm going to have to hire a manager, and you're going to take off to the Bahamas with all

12:52

your money, I'm gonna have to

12:56

pay somebody more than $1 a year

12:56

to take over your job, right? I

13:00

would have to pay them, call it

13:00

$250,000, $300,000 a year.

13:05

Conversely, so I'd have to

13:05

adjust EBITDA right? Because

13:08

really, it's not that. Or you

13:08

were paying yourself $2 million

13:12

a year. And that's great. But

13:12

when I hire somebody, I'm not

13:16

going to pay them 2 million, I'm

13:16

going to pay them the $300,000.

13:19

So I would add that back to the

13:19

earnings, because specifically

13:23

around that particular expense.

13:23

I want to normalize, if you

13:27

will, for what the cost should

13:27

truly be.

13:30

So

13:30

this is giving a sense, a better

13:32

sense, we're making adjustments

13:32

to basically say, what would we

13:36

reasonably expect the EBITDA to

13:36

look like on an ongoing, going

13:40

forward basis?

13:41

That's right. And

13:41

this goes, you know, there's a

13:44

lot of, I think, well trod,

13:44

highly accepted add backs. So

13:50

let's think, take that one step

13:50

further, if you own the

13:52

building, which we operated in,

13:52

and we paid you rent, again,

13:56

same thing, that could be way

13:56

above market, or way below

13:59

market. And if someone else is

13:59

going to buy your company, they

14:02

want to have a lease, that's

14:02

probably market facing, you

14:06

know, what's the market value of

14:06

the lease, so we can get a long

14:08

term. So I could adjust the

14:08

EBITDA for that, either higher

14:11

up or down. These all can be

14:11

very good things, right? There's

14:17

nothing wrong with this, where

14:17

this can get a little crazy, if

14:21

people started adding back a

14:21

whole bunch of really wild

14:24

stuff. And if an advisor ever

14:24

wants to do that, that can be a

14:29

problem because this is not

14:29

going to be defensible when you

14:31

go out. I know you had an

14:31

interview with Cheryl.

14:35

Cheryl

14:35

Aschenbrener of Sikich. Yep.

14:37

And they come into what's called equality of earnings. They will come in and

14:39

do a sell side or a buy side

14:43

quality of earnings. And they'll

14:43

look at all that and say, how do

14:46

they make their money and part

14:46

of that effort, will be looking

14:49

at if there's proposed add

14:49

backs, how defensible those are

14:52

or aren't.

14:53

One of the questions that we often get when people start to get

14:55

into a transaction and

15:00

understand that, you know, Mark,

15:00

as you've often said, selling

15:03

your business or a transaction,

15:03

whether you're selling your

15:06

business or raising capital

15:06

isn't cheap to do. And so when

15:10

we come back from the break,

15:10

let's talk about how transaction

15:14

expenses are treated relative to

15:14

EBITDA.

15:19

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16:30

Welcome back, I'm here with my

16:30

co host, Mark Gaffin. And today,

16:33

we're talking about EBITDA. So,

16:33

just before the break, we were

16:37

talking a little bit about

16:37

add-backs and adjusted EBITDA.

16:42

Specifically, one of the

16:42

questions that often comes up is

16:45

around transaction costs. So

16:45

that's another cost that

16:49

typically would be added back to

16:49

an EBITDA as an adjustment to

16:55

get to adjusted EBITDA, right?

16:57

Yes, and I would

16:57

put that in a larger family of

16:59

specific, one time, if you will,

16:59

highly identified and discrete

17:05

costs. And look at that might

17:05

have been a year ago, you had a

17:12

very rare lawsuit, someone

17:12

slipped and fell in your store,

17:16

and you settled it for $10,000,

17:16

right? We don't expect that to

17:19

recur, it was relatively

17:19

extraordinary to us. So we would

17:22

try to add that back and say

17:22

that $10,000- we don't expect

17:26

that to happen all the time. And

17:26

there may be other things like

17:29

that, if you moved stores or

17:29

moved locations and you spent

17:35

$75,000 in moving locations.

17:35

That's not going to happen every

17:40

year. So we want to add that

17:40

back. And again, to your point,

17:43

if you're doing a transaction,

17:43

and you get 3 to 5 to 6% of

17:47

fees, you know, it's

17:47

accountants, its advisors, its

17:51

lawyers, you say, okay, that is

17:51

not going to be an ongoing

17:55

expense, we can add that back to

17:55

the EBITDA.

18:00

And sometimes there are extraordinary expenses to the

18:02

upside as well. I'm sorry, not

18:05

expenses, but could be

18:05

extraordinary revenue items as

18:08

well. Right? If I think about,

18:08

now typically, it would be, if

18:13

you will, the buyer that's going

18:13

to come back and argue "No, that

18:15

really was extraordinary and

18:15

should be taken out." Probably

18:18

not going to be the seller.

18:18

Although, often the seller also,

18:21

again, they want to put forth

18:21

something that is optimistic,

18:25

but realistic, so that you're

18:25

not getting down, deep into

18:30

negotiations and then discover

18:30

that something is completely

18:33

different than what was

18:33

represented. But I can imagine

18:36

where you also might have

18:36

something to the upside. And

18:38

actually, isn't there a question

18:38

about very related to that,

18:42

about how companies are treating

18:42

PPP money this year?

18:45

Yeah, I think

18:45

that's interesting, because I

18:47

think that the jury's a little

18:47

bit out, there's a lot of mixed

18:50

signals and I don't pretend to

18:50

be a CPA accountant. I know how

18:55

I, as a finance person would

18:55

treat PPP, but actually how it

18:59

flows through the P&L and then

18:59

ultimately, how it's taken care

19:05

of within a transaction itself

19:05

are very, very different. So

19:09

yeah, I think that's a very

19:09

specialized topic. And we should

19:12

cover it I think we should have

19:12

a accountant on here, we could

19:15

bounce some ideas off of because

19:15

we are seeing some emerging

19:19

guidance from the Small Business

19:19

Association Administration and

19:23

how to handle PPP. But no,

19:23

you're right. And look, there

19:26

are some extraordinary revenue,

19:26

I'm not as quick to discount

19:33

those. Because my point would be

19:33

well we are always

19:35

opportunistically looking for

19:35

deals. So I don't, I wouldn't

19:39

try not to if that may catches

19:39

on, you have the discussion, but

19:44

you know, I'm not one to lower

19:44

EBITDA on a client unless

19:48

there's a good reason to.

19:50

Fair

19:50

enough. Fair enough. We've

19:52

talked about so far, what is the

19:52

EBITDA? How does that measure

19:57

fit in the context of some of

19:57

the other measures that we talk

20:00

about, free cash flow, the

20:00

different kinds of profit. We've

20:03

talked about why we use the

20:03

EBITDA, and what adjusted EBITDA

20:08

is and how you make some of

20:08

those adjustments. What some of

20:11

those common adjustments are.

20:11

Before we wrap up today, I want

20:14

to talk a little bit about how a

20:14

potential buyer would be looking

20:20

at EBITDA. So we talked about

20:20

this briefly, in considering why

20:25

buyers like EBITDA. Because

20:25

they're looking at a number of

20:28

different perspective deals,

20:28

they need a way to weed through

20:31

them quickly. And so again, if

20:31

it becomes that shortcut to be

20:34

able to say, you know, this is

20:34

at my threshold, or you know,

20:38

it's large enough for me to be

20:38

interested in or too large for

20:41

me to be interested in. But when

20:41

we get past that first screen,

20:47

how is a buyer looking at

20:47

EBITDA?

20:50

Well, I think that's right, people have to draw a line somewhere because

20:52

EBITDA has got a currency, you

20:55

know, it gives you a good idea

20:55

of what a company is. If someone

21:00

says, I've got a SaSS company

21:00

with EBITDA of $3 million. In my

21:06

head, I'm already calculating,

21:06

okay, what do I think the growth

21:09

rate is there? What do I think

21:09

the margins are there? Because I

21:12

would know from doing SaSS

21:12

companies, right? And so I'm

21:15

like, "Okay, based on what

21:15

you're telling me, these are

21:19

kind of the trading multiples

21:19

that we've seen in that world."

21:22

But if I came in, and your

21:22

growth was very, very different,

21:25

high or low, then I would adjust

21:25

that, right? So I wouldn't just

21:30

trade off the EBITDA. Because

21:30

there's an implicit growth

21:34

multiple in the EBITDA multiple

21:34

of a transaction. Right? If it's

21:39

low, if you've got a wonderful

21:39

solid value added manufacturer

21:44

in the middle market with an

21:44

EBITDA of $1 million, they're

21:47

not going to trade at the same

21:47

multiple as a SaaS company with

21:51

the same EBITDA number. Okay. So

21:51

if you're at the country club,

21:56

and you hear somebody saying, I

21:56

sold my company at 14 times

21:59

EBITDA. That's terrific if my

21:59

company's exactly like theirs.

22:03

If it's not, then I can take

22:03

that as interesting, but I've

22:07

got to make adjustments for what

22:07

my company actually does. And we

22:10

do that when we're putting

22:10

together marketing materials for

22:13

a sell side engagement. We're always trying to make sure that our company has a good story,

22:15

your point on the right story,

22:19

that story shows why this is

22:19

their solid EBITDA, you know,

22:24

it's defensible. Best number you

22:24

can get for us, and then why it

22:29

should trade at the higher end

22:29

of the range for a company like

22:32

that.

22:33

Yeah, going back to your earlier point about, what's sometimes called

22:34

the Country Club Multiple,

22:37

right? It's somebody's out, they

22:37

hear from friends or others that

22:42

they know, others in their

22:42

circle, that somebody sold their

22:45

company for 14 times EBITDA for

22:45

some wonderful multiple. And,

22:51

again, I think from the buyer

22:51

perspective, I always think

22:55

about it is, what the buyer is

22:55

going to come back and look at

22:58

and quite frankly needs to do,

22:58

is they need to both push on,

23:01

what is that EBITDA number? So

23:01

if the company says that their

23:05

EBITDA is 5 million, and really

23:05

when you look at it, yeah, they

23:09

maybe were a little bit too

23:09

aggressive with the adjustments

23:12

or you know, for whatever

23:12

reason, I, as a buyer, look at

23:16

that and say, I really only

23:16

believe that the EBITDA is 4

23:18

million, right? So negotiating

23:18

what that EBITDA is, is one

23:22

critical piece. The second

23:22

piece, then, is being able to

23:26

talk about what multiple is

23:26

appropriate. And as you say,

23:29

both of these are shortcuts.

23:29

Ultimately, though, it is how do

23:34

we get to something that we can

23:34

look at comps in the market,

23:37

that we can understand, what is

23:37

the valuation that's being

23:42

proposed, or the price that's

23:42

being proposed, relative to what

23:46

others are seeing out in the market.

23:48

Right. And I think

23:48

that this is kind of a funny

23:51

little technique that I learned

23:51

in business school and then in

23:54

my first couple years out, in

23:54

strategy consulting, there are

23:59

people that want EBITDA

23:59

multiple, they love it, it's

24:01

easy for them to think about,

24:01

they don't want to see this huge

24:04

model that you're using on a DCF

24:04

and then there's valuation

24:07

ranges that you do. So what you

24:07

can do is say, Well, if EBITDA

24:11

is $10 million dollars, I'm

24:11

going to do this huge model and

24:14

come up with what we would pay

24:14

for the company, whether that's

24:16

an LBO model or DCF model or

24:16

Monte Carlo Simulation, any

24:20

number of things that you could

24:20

use. But we're gonna go pay 100

24:23

million dollars for this

24:23

company, they need to come back

24:26

and say, "Well, it's a 10

24:26

multiple." So everybody's quite

24:29

happy, but you kind of know how

24:29

you got to the hundred million.

24:32

And you just divide by the

24:32

EBITDA so now you've got your

24:35

multiple. But look to your

24:35

point, this is important because

24:39

EBITDA is used in transactions.

24:39

I'm not saying it's a bad

24:44

number, but it's used for EBITDA

24:44

or earnouts. Some are earnouts

24:48

on revenue, some earnouts are

24:48

EBITDA based and so, it is a non

24:53

trivial exercise. Once you start

24:53

to close a transaction, you have

24:57

to LOI and you're documenting it

24:57

to figure, what goes into

25:01

EBITDA, what are the adjustments

25:01

that go into EBITDA. So if

25:04

adjusted EBITDA is a million

25:04

dollars this year, you've got to

25:08

drive this to $1.2 million next

25:08

year on these same adjustments

25:13

to get your earnout you're going

25:13

to care how we calculated

25:17

EBITDA.

25:17

Well,

25:17

this is something that we often

25:19

work with our clients and

25:19

potential buyers on, is how did

25:25

we adjust EBITDA that we're

25:25

using to calculate the price.

25:27

But also, to your point, if

25:27

there's an earnout, which very

25:31

often there is an a transaction

25:31

structure, how are we agreeing

25:36

ahead of time, right? Because

25:36

the last thing you want to do is

25:39

be sitting there at the time of

25:39

that earnout and now be arguing

25:42

about how we're going to

25:42

calculate EBITDA. So I can think

25:46

of a couple of instances

25:46

recently, where we knew that the

25:49

buyer was going to make

25:49

investments, we knew that they

25:53

had other related companies,

25:53

potentially they had a holding

25:58

company that was going to have

25:58

overhead that they might want to

26:02

allocate to the operating

26:02

company. All of those things are

26:04

fine, right? We know that

26:04

they're buying it because they

26:07

want to make investments to be

26:07

able to grow. And that's great.

26:10

However, how do we treat that

26:10

and how do we look at that in a

26:14

way that's fair to both sides,

26:14

as we think about looking at

26:18

that EBITDA at the end of year

26:18

one and the end of year two, to

26:22

determine the earnout that is do

26:22

the original seller.

26:27

I think like with

26:27

any other financial measure, if

26:29

it's open to being manipulated

26:29

too much, then you really don't

26:35

win. It can be used against you.

26:35

I think a real quick story in

26:40

the leverage lending world.

26:40

There was concern back in 2013

26:44

and 14 about over-levered deals.

26:44

People were doing deals that

26:48

were north of six times EBITDA-

26:50

And over levered means?

26:51

Too much debt. So

26:51

the government, the regulator

26:56

started getting all up in arms

26:56

about that. And people said,

26:59

Well, if six times EBITDA is

26:59

your problem, and they were

27:03

using adjusted EBITDA, then

27:03

they'll just allow more add

27:06

backs in and then magically, all

27:06

the sudden the deals were all

27:08

right at six times, EBITDA, the

27:08

upper end deals. Doesn't mean

27:13

the banks weren't doing their

27:13

normal work, to do all of what

27:16

we're talking about, which is

27:16

cash flow from operations, cash

27:20

paying taxes, cash available

27:20

after paying for capital

27:25

expenditures, you know, that's

27:25

what they care about. They care

27:28

about cash that's available to

27:28

pay them after operating the

27:31

company. But they're like, Look,

27:31

if there's a problem with, you

27:35

know, we'll just use adjusted

27:35

EBITDA. And that's what people

27:37

are doing, adding all kinds of

27:37

things into EBITDA to get the

27:40

debt multiple down. Not useful.

27:44

The other interesting thing right now is obviously given that

27:45

EBITDA is, you're starting with

27:49

revenue, at the top line and so

27:49

one of the questions right now

27:54

is also, how are buyers and

27:54

investors looking at 2020

27:59

revenue, and foreshadowing

27:59

Cheryl Aschenbrener of Sikich,

28:04

who we've already talked about

28:04

on this episode, is actually

28:06

going to come back and join us

28:06

in another couple of weeks. I

28:10

know, excited to have her back.

28:10

And we're going to talk about

28:14

exactly that. I mean, we've seen

28:14

everything from potential buyers

28:18

saying, look, we know that 2020

28:18

has been a crazy year. So let's

28:22

just use 2019 to trying to

28:22

figure out how we treat it in

28:26

add-backs. So looking forward to

28:26

a really robust discussion with

28:31

Cheryl about what are the

28:31

different ways we can think

28:35

about perhaps a typical revenue

28:35

in 2020? And how is that being

28:41

treated in transactions?

28:42

Yeah, and I think

28:42

there's ,I want to give you my

28:47

view, this is Mark's view, this

28:47

is not anybody's view. This is

28:50

not necessarily correct. I've

28:50

seen the mugs out there,

28:53

EBITDAC, so now we're going to

28:53

have COVID, you know, "C" on

28:57

there.

28:57

EBITDAC, for those who might have missed the episode with Cheryl is

28:59

adding Coronavirus to the very

29:03

end. So earnings before

29:03

interest, taxes, depreciation,

29:06

amortization and COVID.

29:09

So I think that if

29:09

I looked through somebody's

29:12

financial performance, and they

29:12

were, again, very specific

29:16

things that they needed to do

29:16

with the response to COVID, lets

29:20

just be extreme, put Plexiglas

29:20

up in front of all their tellers

29:25

or whatnot, right? That's not

29:25

anything we're gonna have to do

29:27

again, and hit the P&L with an

29:27

expense item. That I can see

29:31

saying, add that back, because

29:31

it's a very discreet, not

29:35

typical operating expense. But

29:35

some of the things like

29:40

lostrevenue or compressed

29:40

margins, I want to be very

29:43

careful with that. Because to

29:43

me, that is yes, it was a shock

29:48

to the entire system. But I

29:48

think that I would want to know

29:51

as an ambassador, how did that

29:51

company handle, how robust was

29:56

the cash flow to external shocks

29:56

like that, because, look if I'm

30:00

buying a company, I'm buying it

30:00

with a very long time horizon,

30:03

probably if even a financial

30:03

investor, it's five to seven

30:06

years. So there's probably going

30:06

to be something else out there,

30:10

whether it's a recession,

30:10

geopolitical disruption or

30:13

something. So I would want to

30:13

not just dig it for that but I'd

30:16

want to be really thoughtful

30:16

about how resilient was the

30:19

supply chain? How resilient was

30:19

my clients, my customers, or

30:23

could they just shut me down and

30:23

I lost 80% of my revenue in two

30:28

weeks?

30:29

Right.

30:29

And that is, you know, I think

30:32

we've talked before about in

30:32

202o, one of the ways that we're

30:35

seeing people address this is

30:35

looking at, what was the

30:38

strength of the company before

30:38

the shutdown? What happened

30:42

during you know, I would say,

30:42

obviously, we're still in the

30:46

Coronavirus, time, but during

30:46

the worst of the shutdown, and

30:49

now, what does the bounce look

30:49

like? So if it was a hard shut

30:54

down, but there's been a strong

30:54

bounce, that's one profile. If

30:57

it's, you know, been a different

30:57

profile of maybe a slow decline

31:02

or a slow increase, or a rapid

31:02

increase. But again, if we go

31:05

back to the general principle of

31:05

how do we adjust EBITDA to be

31:11

able to look at what is a

31:11

reasonable expectation of the

31:15

EBITDA going forward? To me,

31:15

that's how you look at what's

31:18

happened in 2020.

31:20

That's right. And I think you have to look at in the context of what happened, right?

31:22

We just got the new GDP numbers

31:25

out for the third quarter, you

31:25

know, up 33%, and you look at

31:29

the second quarter, they were

31:29

down whatever, 35, 36% on an

31:33

annualized basis. So I can't

31:33

look at what happened to this

31:37

little company without taking

31:37

that into consideration. Did it

31:41

bounce? What is required and how

31:41

quickly they get back on track?

31:45

So again, that goes to, it's

31:45

going to be very difficult to

31:48

just use EBITDA a trailing 12

31:48

month EBITDA on October 31,

31:54

tomorrow, and just say, there,

31:54

there's my EBITDA, right? So

31:59

it's a great shortcut. It really

31:59

is. It's going to be adjusted

32:04

when we do things in the finance

32:04

world. But also, it can be

32:09

useful.

32:11

I think that's a great summary. And so with that, I'm Stephanie

32:12

Chambliss. Gaffin. And you've

32:15

been listening to Right in the

32:15

Middle Market, a podcast about

32:18

running, growing and selling

32:18

your middle market business.

32:21

We'd love to hear your comments

32:21

about today's episode and

32:23

whether this helped you get a

32:23

better understanding of EBITDA

32:26

and tell us what ideas you'd

32:26

like to hear about most in the

32:29

future. Send me a message on

32:29

LinkedIn or drop me a line at

32:32

[email protected]. And be

32:32

sure to subscribe to hear more

32:36

pragmatic tips from upcoming

32:36

episodes. Until next time, be

32:40

well and be deliberate.