Recasting EBITDA is an accepted practice in the presentation documents that are produced to facilitate a business sale by a sell-side M&A firm. The purpose is to strip out expenses that would no longer be incurred by the eventual buying company.
Representative Categories for Recasting
The obvious ones are the I = interest, the T = taxes, the D = depreciation and A = amortization defined in the EBITDA formula. In addition to these are numerous add-backs that are legitimate depictions of expenses that would no longer be incurred by the new owners. Below are several examples:
- Salary in excess of market for the current owner
- Salary in excess of market for an employed family member (or completely eliminate this position)
- One time legal fees
- One time professional fees (the most common is the engagement fee from the M&A Firm)
- Auto expenses for the owner's luxury car
- Owner's discretionary travel expenses
- One-time bad debt expenses
- Premium health insurance
- Owner life insurance
- Rental to related party in excess of fair market value
- Misc gray area owner personal / business expense categories
The Impact on Company Value
The impact on the restated performance of the company can be quite significant from a company valuation perspective. If, for example, the P&L EBITDA were $500,000 and the industry standard valuation multiple were 5X EBITDA, the implied company value would be $2.5 million. By applying the recast items for this example of $250,000, the resulting EBITDA is $750,000 and the company value at the same multiple is now $3.75 million. This is a impactful presentation that does have some sway with the potential buyers. Below is an example of what this recasting analysis might look like for a small technology company
Client Example from the Memorandum
EBITDA Recasting Category
(1) Shareholder's Compensation
Reclassified shareholders Compensation
Adjust Shareholders Compensation - According to Management FMV to replace CEO is $175 K
(2) Indirect salaries and commissions
Reclassified shareholder's compensation
(3) Travel and entertainment
(4) Professional Services
Remove discretionary consulting fee
Officer's discretionary life insurance
(6) Bad Debt Expense
Remove non-recurring bad debt
(7) Non-Operating Income
Remove non-operating gain on debt forgiveness
(8) Other Expenses
Remove non-recurring LT debt release fee
(9) Interest Expenses
Remove Interest - pre-debt analysis
Adjustments to Historical Shareholder's Compensation
Estimated annual fair market compensation
Less historical compensation
Example of An Owner's Attempt at Recasting
Technology clients generally do a great deal of research on the M&A process prior to reaching out to discuss a possible engagement. They are well-versed on who bought who in their market niche and what the transaction value was. They research the mergers and acquisitions process and recognize the leverage of the EBITDA recasting to position their company for a lucrative exit. Unfortunately in their exuberance to apply their newly found value enhancement technique they often take an approach that no buyer will embrace.
Here is an example of what I got from a recent potential client in the form of a PowerPoint presentation (nothing like selling the salesman). The names are changed to protect the innocent:
From total sales in 2016 of $2,907,675, on an acquisition, the following are reduced expenses: (Salaries)
Key Employee 1 $152,000
Key Employee 2 $78,000
Key Employee 3 $49,000
Key Employee 4 $44,000
(Salary and Distribution)
Hourly Employee 1 $20,000
Total Salary Adjustment $663,000
Additional Recast Expense Savings:
Taxes on salaries: $32,000
Health Insurance: $82,000
Computer repairs: $22,000
Trade Press Shows
(not to attend in 2016) $27,000
Loan repayment to AW: $102,000
Owner Perks: $9,000
Total reductions in expenses: $1,021,000
Further calculations from the Owner:
- Total 2016 Expenses: $2,553,675
- Less savings of $1,021,000,equals recast expenses: $1,532,675.
- Total 2016 (cash) sales of $2,907,675 less total recast expenses of $1,532,675 for fiscal year 2016: Net EBITDA of $1,375,000.
- Minimum multiple of 8-13 equals enterprise value on a strategic acquisition between $11 million and $17.875 million
*Please note that a formal valuation was performed on this company using standard practices for EBITDA recasting and both discounted cash flow and market comparables for privately held companies in a similar niche and the value conclusion was between $2.6 and $3.2 million.
Unrealistic Expectations Scare Potential Buyers Away
The owner's complete perversion of the recasting process is damaging in so many ways. First, the buyers are smart people and you can present whatever calculation of recast EBITDA you want. They will do their own calculations according to their own guidelines. It may not agree with the analysis performed by the professional valuation firm, but it will be within a narrow standard deviation. The owner's analysis basically says you are getting a stripped-down company with no key employees and no place to operate. Much of the value of an IT business is contained in their intellectual property, much of which is held by their customer-facing employees. No employees = no value.
The second damaging effect is that the owner is viewed as totally unrealistic and the buyers have been down this path before. There is no light at the end of the tunnel. This will be a waste of time and they devote their scarce resources in trying to move an owner so far back to reality. If they don't pull out initially, it will be a grind of doubting and questioning every bit of information they receive from that point forward.
Where in the world did the owner get a valuation multiple of 8-13X adjusted EBITDA as the appropriate valuation metric for his business? In the earlier example, the company was prepared through their research, but their interpretation of their research is totally flawed. They probably saw a deal announcement where IBM or Microsoft or Google or Facebook bought a "similar company" for $300 million and they backed into a 10X EBITDA multiple using the available data on PE multiples for this public company acquisition. There is no correlation between a $300 million public company with scale and brand and your $4 million company in the same general market space.
We are all about helping smaller tech companies achieve strategic value in their business sale, but we have to be on the same page about the potential of that strategic value. Unless you have a breakthrough for Alzheimer's or an AI algorithm that will wrestle Watson to the ground, your value is going to be mostly controlled by your financial performance. If the starting point for similar small companies in your space and a buyer's CFO and Board of Directors is a sales price of 5X EBITDA—and we can get a transaction done at 7X EBITDA—we believe a 40% premium constitutes strategic value.