The Power of EBITDA in Exit Planning (Part 1)
Today, I wanted to get our hands firmly wrapped around one of the slipperiest numbers in business: your EBITDA.
(note: this is only for privately held companies under $50 million. EBITDA gets wacky with larger companies and public corporations and we’re not going there. this is just for my people, the small and medium closely-held enterprises.)
I don’t want to talk about EBITDA because it’s an important accounting principle and you simply must be aware of it to have a healthy business.
(it’s not even because I’m a word geek who loves to really know what terms mean and why they matter, though that’s true too)
Those are very important reasons.
But, they aren’t my B-I-G reason.
Building Your Business with the End in Mind
I want to talk about EBITDA because, at some point, you are going to want to sell your business.
You are building your business with the end in mind.
(our favourite thing)
And that means that you must know your EBITDA so that we can get an estimation of the value of your company and begin to increase it in two ways:
- through increased revenues, and
- through an increased EBITDA multiple
(hint: your accountant knows your EBITDA… or, if they don’t know it, they can figure it out in about 5 minutes. Shoot them an email right now and ask them for your EBITDA for each of the last 3 fiscal years. You’ll be happy – or at least enlightened – that you did.
double hint: make it part of your regular bookkeeping so you always have an eye on this very important number, at least quarterly, if not more frequently)
While you can certainly increase your multiple without knowing your EBITDA, doesn’t it make more sense to actually know what those letters stand for while you grow your business?
I think so. My clients think so.
Let’s unpack that ridiculous acronym and figure out why it’s so useful.
Unpacking Your EBITDA
EBITDA = Earnings Before Interest Taxes Depreciation + Amortization
(this is where I fall on the floor laughing because, holy moly, that’s a lot of words that need explaining. Courage! Onward!)
Okay, let’s start at the beginning.
Earnings = these are NOT your gross revenues. They are your net income (basically, your operating profit), the money that is left over after you deduct all the operating expenses and production costs.
Before = this means that regular expenses have already been deducted from the Earnings, but not the rest of the stuff to follow.
Interest = the money you have to pay to service your debts. The interest on your line of credit, credit cards, accounts payable, small business loans, notes, etc.
Taxes = the money you have to pay the government for the privilege of running a business.
(I know it often doesn’t feel like a privilege, but it really is. Our businesses are also the economic drivers so it’s a fair trade.)
Depreciation = an accounting technique where expensive capital assets (the equipment you own: machines, cars, computers, etc.) are shown to decrease in value over time according to specific formulas. It can save you money now but might cost you a lot in the future so be careful here if your accountant is into aggressive depreciation.
Amortization = an accounting technique where intellectual properties and other non-tangible assets of the company (like patents and copyrights) have their value calculated out over the lifetime of the asset. Just like with capital assets and depreciation, the value of the asset is calculated to decrease over time.
Phew! Let’s grab a cup of tea, shall we? A few deep breaths?
Honestly, it’s mostly accounting gobbledy gook.
What you need to know is that your accountant knows all of these things and can get you the number when you ask for it.
You also need to know that by increasing your revenues and decreasing your expenses, you can increase the ‘E’ of your EBITDA and thus increase the value of your company.
Fine-Tuning Your EBITDA
Ultimately, EBITDA is a convenient number to estimate the profits that your company generates each year that a new Owner would be able to use without taking into account:
- the tax burdens (that you can do very little about),
- the debt service (that is not really part of the structure of your Operations),
- and the accounting strategies (that can change with new Owners and, again, have very little to do with the structure of your Operations).
Why is Interest included?
Because it is assumed that, in the sale of your business to the new Owner, all debts will be paid off.
(think about that for a moment. Does your debt load need some attention? Can you imagine it being paid off quickly?)
Depreciation and Amortization are included because they aren’t really real numbers. They are accounting principles that allow you to diminish the value of your tangible and non-tangible assets over time.
Also, as mentioned above, D+A are something you really need to keep an eye on because, for instance, your accountant might be happily depreciating your very expensive machinery each year and if you have it for long enough, you might even get close to zero with depreciation.
When you go to sell your business, along with that equipment, it will have value (remember that depreciation is a technique, not a real number) and you will end up paying mucho tax on it. Be aware. Talk about it with your tax professionals. Make sure you’re not eliminating your future profit by saving money now with depreciation.
And Taxes are included because there are ALWAYS taxes and regardless of how the money comes in and how it is used, taxes eventually have to be paid.
Knowing your EBITDA will give you the power to assess and change it.
One of the ways that many of my Owners adjust their EBITDA is by adding back in ‘discretionary’ expenses such as cars, trips, and coaching that they have chosen to be part of their legitimate business expenses but that are not necessary to business operations and success.
That one tweak can significantly increase the ‘E’ part of your EBITDA by decreasing expenses, increasing profit. And, as we’ll learn in Part 2, any increase in your EBITDA is magnified by the multiple. That’s a very good thing.
Your EBITDA and Business Building Success
When you work with your EBITDA, what you’re left with is an approximation of the profit of your company over that time period.
And what a new Owner wants to know, after all, is how much money they will receive on their risky investment into your company. What their return on investment will be.
(and, yes, investing into a privately held business is ALWAYS a risky investment, even if you’ve got the best business in the whole darn world, which, of course, you do)
When you use your EBITDA as one of your key indicators, you will be keeping an eye on operating profit, as well as on how much you are paying for debt service, taxes, and asset depreciation.
You’ll be able to shift and adjust the EBITDA over time to create a number that is deeply satisfying to both you and to potential buyers.
In Part 2, we’ll look at the magical EBITDA multiple and how to maximize it and how that impacts the value of your company on the open market when you go to sell.
Read Similar ArticlesPosted in: Advice for Business Owners, Exit Planning
Tagged as: business building, EBITDA, profit, selling my business