EBITDA – What’s it all about?

EBITDA may seem to be the holy grail of business assessment in the M&A world. Almost every potential buyer starts by asking what is the selling company’s EBITDA; and almost every seller wants to know at what multiple of EBITDA his or her business will sell for.

From an accounting standpoint, EBITDA is a simple concept: Earnings Before Interest, Taxes, Depreciation and Amortization. However, it has also been referred to as “Earnings Before I Trick D’Auditor”. Why would someone characterize it that way? Because, as it turns out, EBITDA may not be such a simple concept. For example:

  • EBITDA is really a “proxy” for “free cash flow” which is difficult to determine from an income statement alone
  • Is the EBITDA as reported or has it been “normalized” or adjusted for discretionary, nonrecurring and nonoperating items?
  • What timeframe was used? Calendar year, fiscal year, long-term average, trailing twelve months, or projected?
  • Are liabilities or forecasted earn-out payments, for example, included in what’s being valued when a multiple is applied to EBITDA?

What else should be considered when relying on EBITDA?

  • EBITDA essentially ignores real cash items such as interest and taxes, as well as changes in working capital that a company needs to fund day-to-day operations
  • While depreciation and amortization are non-cash items, adding them back makes a company appear to have more cash flow than it really does, since capital assets being depreciated will have to be replaced eventually
  • Private Companies can manipulate EBITDA as it is calculated from an income statement that may contain exaggerated income or under-reported expenses.
  • Earnings quality is often overlooked
  • In an actual transaction, the multiple is different for the buyer and seller
  • Despite the concerns above, EBITDA, when properly developed, is still a good method to evaluate and compare profitability. The most efficient and effective operators in an industry will have the highest EBITDA as a percent of sales.

In sum, EBITDA is just a starting point to developing a thorough, clearly-explained and well-supported measure of expected cash flows. It is important to trust business valuation to certified and experienced specialists who understand that it’s just not that simple.


Proposed IRC Section 2704 Regulations – What’s all the fuss about?

Long-awaited proposed regulations under section 2704 of the Internal Revenue Code, released on August 2, 2016, would make sweeping and very significant changes to the valuation of interests in many family-controlled entities for estate, gift, and generation-skipping transfer tax purposes. For decades, the IRS definition of Fair Market Value (FMV), which is based on the concept of the hypothetical financial buyer, are typically completed on a control basis (more than 50%, but usually 100%), as most if not all buyers would have no interest in acquiring a minority position.

Many in the business valuation community feel that the proposed regulations introduce a new standard of value, with an unknown definition, that goes against years of accepted valuation theory and Tax Court precedent. In estate planning, which under the current and long-standing IRS FMV standard, provides discounts for lack of control and lack of marketability when minority interests are transferred to family members as part of the family’s estate planning or if a minority percentage of stock is being sold. That’s because in keeping with the FMV standard, the hypothetical buyer would not likely pay the same price for a minority share of a company as they would for a controlling share.

On April 21, 2017, President Donald J. Trump issued Executive Order 13789, a directive designed to reduce tax regulatory burdens. The order instructed the Secretary of the Treasury to review all “significant tax regulations” issued on or after January 1, 2016, and submit two reports, followed promptly by concrete action to alleviate the burdens of regulations that meet criteria outlined in the order. Specifically, the President directed the Secretary, in consultation with the Administrator of the Office of Information and Regulatory Affairs, to submit a 60-day interim report identifying regulations that (i) impose an undue financial burden on U.S. taxpayers; (ii) add undue complexity to the Federal tax laws; or (iii) exceed the statutory authority of the Internal Revenue Service (IRS).

The proposed IRC Section 2704 Regulations have been vigorously opposed by the appraisal community, lawyers, CPAs, wealth planners and business owners who testified before the IRS in unprecedented numbers (in more than 30 years). According to Catherine Hughes, attorney-advisor at the Treasury, “We will make it clear that these regs will not eliminate minority discounts.” This doesn’t mean that discounts won’t be significantly reduced, which they will be under the regulations as currently written. Although the effective date of any such regulations is uncertain, it’s likely that only transfers that are completed prior to the effective date (for example, completed gifts of partnership units or sales of them) will be grandfathered from the new rules.

While the fuss continues, it may be prudent for business owners intending to make such transfers to contact their advisors now rather than later.

Which Business Valuation Will Facilitate Negotiation?

You are getting ready to sell your business so you must ask yourself some questions:  When do I want to exit?  Who are the most likely buyers?  Is my business adequately prepared to sell?  How does it compare to other like businesses?  And of course, what’s my business worth?

All business valuation relies on some prediction of the future. Business appraisers apply a variety of adjustments to financial statements, theoretical constructs and historical data to divine the future. Numerous valuation approaches and methods are used, but the most common valuation formula is quite simple:

Value = Expected Cash Flow / Risk Adjusted Expected Return

Private equity firms often bypass valuation theory and use their judgment to apply a multiple on adjusted EBITDA (a common but incomplete proxy for cash flow) after scrubbing the financials and gaining a basic understanding of the business.

Likewise, buy-sell agreements often call for a specific price formulas. The advantage in this method is that it’s easy to understand and appears to be a cost-effective way to value a business.

Simplicity is a good thing, except when it conceals or misses important information. For example, let’s say your industry has businesses that have sold between 3-6x EBITDA. How can you understand where your company deserves to be within that range? Not knowing can be costly — either in terms of not getting a deal done because you held out for 8x EBITDA, or because you sold for 3x, when you could have received 5 or 6x.  Improper valuation can easily result in hundreds of thousands or millions of dollars of lost opportunity.

A buyer seeks a reasonable return on their investment, without excess risk. Your task as a seller is to persuade buyers that the cash flow they see will adequately compensate them for the risk of the business. Without a clear understanding the various cash flow adjustments and factors that determine risk, and how that translates to market value, you enter the negotiation unprepared.

A business valuation performed by an experienced professional makes good and common sense. It will help you make better decisions when considering your various exit options.

Hidden Problems with the Price Formula in Your Buy-Sell Agreement, and Solutions

It is tempting to select a formula approach to pricing shares when business partners come and go. After all, a formula is easy for everyone to understand, and in theory at least, inexpensive to apply. If you’re satisfied with getting to a price, any price, then congratulations – job done. But the goal is to arrive at a price that is fair to all concerned. This article discusses some of the unforeseen problems with buy-sell pricing formulas that we as valuation experts encounter frequently.

As a quick introduction, buy-sell agreements usually employ one of three basic approaches to pricing shares upon buy-sell trigger events (when a shareholder retires, dies, becomes disabled, etc.):

  1. Fixed Price: Shareholders agree on a price per share and agree to periodically revisit that price.
  2. Formula: Shareholders agree on a formula to calculate share price. Examples include: book value; adjusted book value; 4 times trailing 3 years average EBITDA, etc.
  3. Independent Valuation: Shareholders agree on a professional business appraiser to determine fair market value (or another appropriate standard of value).

The pricing method prescribed in your company’s operating agreement, by-laws, or shareholder, buy-sell or stock restriction agreement, as the case may be, is important to the success of your next buy-sell transaction. So, what are these hidden problems with the formula method?

Businesses evolve, and formulas are static

No single formula will consistently produce a fair market value result year in and year out. It is common, for example, for companies to move from a project-based model to a recurring revenue model over time. The latter sell for higher multiples, yet the multiple stated in the buy-sell agreement still reflects the old business model. In this scenario, the buyer wins and the seller loses. Formulas don’t capture changes in the business, and eventually become irrelevant. Shareholders usually have every intention of updating pricing formulas, but in practice buy-sell agreements get filed away and forgotten about, and their formulas become stale. As years go by and shareholders’ interests diverge (some become buyers and some become sellers), renegotiating a formula to bring it in line with market value becomes increasingly difficult.

Value is forward looking, and formulas aren’t

One of the central tenets of valuation is that the value of an operating business is based on expected future financial returns, considering risk and market conditions at a point in time. Valuation is therefore a forward-looking concept. Past performance may be a strong indicator of what to expect going forward, or it may not. Let’s say a manufacturing company has invested heavily in new product development for the past three years or has just added significant equipment to increase production capacity. A multiple of earnings formula would grossly under-value the shares in this case. In our work testing buy-sell formulas and providing benchmark valuations, we find that prices determined by formulas often bear little resemblance to fair market value.

Formulas are seldom 100% replicable

I’ve seen three reasonable financial experts apply the same price formula to a company and arrive at three different answers because there were at least three ways to interpret the formula. Rarely do we see pricing formulas that are totally unambiguous. When the formula was created, no one was sweating the details. Years later, when buyers and sellers emerge, a formula that leaves room for interpretation will almost certainly result in a dispute. While seemingly straightforward, a pricing formula that is not designed by a seasoned valuation professional is very likely not 100% replicable.

Formulas can create the wrong incentives

An earnings formula creates a disincentive for a managing shareholder to invest in operations toward the end of his or her reign. If he or she expects to be paid a multiple of EBIT, they might hold back from making investments that fuel growth or allow the company to remain competitive. The exiting shareholder receive more per share, while reducing future cash flows, which reduces actual value. Conversely, an unscrupulous controlling shareholder who knows that other shareholders are nearing retirement, could overspend for a few years to reduce EBITDA and therefore the buyout price. It does happen.

Bottom line; pricing formulas often yield results that are not true economic values. They produce winners and losers, which leads to hard feelings, disputes, and sometimes litigation, which becomes shockingly expensive, time-consuming and disruptive; and destroys shareholder value for all concerned.

All of the above shortcomings can be overcome by having a valuation-based buy-sell agreement and appointing a qualified and experienced business appraiser. However, if you insist on using a formula, I recommend that you at least hire a valuation expert to do a benchmark valuation of your company and design a formula that is more accurate, more replicable, and more robust. Then have that appraiser update the valuation and test and revisit the formula every three years or so.

If you would like to have your buy-sell agreement objectively reviewed from valuation, economic, fairness and practical business perspectives, please give us a call. Al Statz, ASA, CBA, can be reached at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Make No Mistake: The IRS is Serious About Qualified Appraisals and Appraisers

The IRS and the Tax Courts are serious about requiring taxpayers to properly determine the value of non-cash estate assets, gifts and charitable contributions. To avoid having the value of an inherited, gifted or donated privately-held business interest challenged or rejected by the IRS, obtain a qualified business appraisal (valuation) from a qualified business appraiser.
The IRS defines a qualified appraisal as one that:
  1. is performed in accordance with generally accepted appraisal standards;
  2. meets the relevant requirements of IRC Regulations section 1.170A-13(c)(3) and Notice 2006-96, 2006-46 I.R.B. 902;
  3. does not involve an appraisal fee based on a percentage of the appraised value of the property;
  4. includes specific information, such as a property description, terms of the sale agreement, appraiser identification information, date of valuation and valuation methods employed, among other requirements;
  5. in the case of a charitable donation, is made not earlier than 60 days before the property is donated, and in the case of gifted property is as of the date of gift; and
  6. is conducted, prepared, signed, and dated by a “qualified appraiser.” (see below)
Their definition of a qualified appraiser is an individual who:
  1. Has earned an appraisal designation from a recognized professional appraisal organization (such as the ASA, NACVA, IBA, or AICPA) or has met certain minimum education and experience requirements;
  2. Regularly prepares appraisals for which the individual is paid;
  3. Demonstrates verifiable education and experience in valuing the type of property being appraised;
  4. Has not been prohibited from practicing before the IRS under section 330(c) of Title 31 of the United States Code at any time during the three-year period ending on the date of the appraisal; and
  5. Is not an excluded individual (mainly, someone who is the donor or recipient of the property).

In-depth information on determining the fair market value of donated property can be found here, in IRS Publication 561 (Form 8283).  https://www.irs.gov/uac/about-publication-561

Taxpayers and tax practitioners need to pay very close attention to the credentials and experience of the business appraiser they hire, and be sure that the type of analysis and report that the appraiser intends to provide will fully comply with IRS requirements. When you need a business valuation or appraisal for a tax filing, Exit Strategies’ experienced valuation professionals would be happy to help. To discuss your particular business interest and valuation needs with a qualified expert, you can reach Al Statz, ASA, CBA, at 707-781-8580.

Case Study: How One Entrepreneur’s Advisors Enabled a Successful Estate Transfer

I recently had a client who wanted to transfer his medical distribution company to his son and retire with peace of mind — a common occurrence these days. Dad and his CPA requested an opinion of Fair Market Value to set the price for a transfer of stock. After I appraised the company (S corp.) stock at $2.0 million, Dad and Son asked me how to finance the transaction. Dad was reluctant to carry a long-term loan for his son — also a common occurrence! Here’s how a team of advisors helped the client make this happen …

The lenders that I approached wanted Son to inject a minimum of $500K (25% of the deal price). This turned out to be a lot more than the son had available. One creative lender suggested that Dad finance the sale for a short time until Son had paid down 25% of the principal on Dad’s note, then return to him for an SBA loan.

The lender proposed 3 seller notes totaling $2 million: Note1 for $500k (25% of the purchase price) for two years, fully amortized; Note2 for $750k with interest-only payments, due in 2 years; and Note3 also interest-only and due in 4 years. The plan was that as soon as Note1 was paid off, the lender would take out Note2 to Dad with a $750k 10-year term loan. Then, after that bank loan was seasoned for 2 years, the lender would lend the remaining $750k to take out Dad’s Note3. The result: Son can acquire the business with no money down, Dad can be completely paid off in 4 years, and Son will have the flexibility of a long-term loan.

When Dad and Son were ready to finalize their agreement, they called a meeting with me and their attorney and CPA. I discovered one significant problem. Under a stock sale, Son’s expected salary and distributions, after taxes, were not quite sufficient to cover his debt service (principal and interest payments) and living expenses in the first two years.  During the meeting, I suggested doing an asset sale-purchase instead of the planned stock deal. In an asset purchase, the Son’s net after-tax cash flow would be substantially increased by the stepped up basis of fixed assets and intangibles. After providing rough calculations, Dad and Son received definitive tax advice from their CPA.

Cash Flow Benefits

Let’s look at an example of the difference in cash flow in an asset sale versus a stock sale.  Assume a $2,000,000 price in both cases, with inventory and fixed assets as shown in the table below, as well as price allocations to covenant not-to-compete and goodwill under an asset sale.

Asset Sale – BuyerStock Sale – Buyer
Inventory$400,000 (not deductible)$400,000 (not deductible)
Fixed Assets$100,000 (new basis)$25,000 (existing basis)
Covenant not-to compete$50,000na
Buyer’s total deductions against income$1,600,000$25,000
Depreciation of Fixed Assets$20,000 / year, 5 yrs*$5,000 /year, 5 yrs*
CNTC & goodwill combined$100,000 / year, 15 yrs$0
Total deductions, years 1-5$120,000$5,000

*Assume all fixed assets have 5-year depreciation

With an extra $115,000 per year in deductions, and assuming a combined state and federal tax rate of 40%, the Son’s after tax cash flow in an asset purchase would be $46,000 more. Under this structure, the Son’s cash flow would be sufficient to support the debt and enable the ownership transfer.

Dad and Son are now almost a year into their transition. Son is faithfully paying down Note1, the business is doing well, and Dad and Son are happy.

The first moral of this story is that business succession planning and estate planning are team sports, where entrepreneurs need a team of experts to guide them. No single professional is qualified to advise on the range of succession and estate issues that arise.

The planning process often begins with an appraisal of the business and real estate assets, so that tax, financial and legal professionals, lenders, insurers and other team members understand the assets to be transferred. The second moral is that when a business is part of an estate transfer, as in this case, selecting a business appraiser with experience in structuring and financing business sale transactions can be a big advantage!

For further information or to discuss a current need, contact Bob Altieri at ESGI.

Twenty Reasons to Know the Value of Your Company

Private company owners and shareholders seek independent business valuations at various times for various reasons. Here are twenty situations in which you may want to obtain a business valuation:

  1. An owner has passed away and a valuation is required to settle the estate per IRS regulations
  2. An owner is getting divorced and needs to have the company or their fractional interest valued to settle the marital estate
  3. An owner wants to gift shares to his or her heirs
  4. Business acquisition financing
  5. Owners need an independent opinion of value to comply with provisions of the company’s shareholder or buy-sell agreement
  6. A management buyout (MBO): the business can be valued on behalf of the current owners, or management or both
  7. When considering selling, merging with another company, or acquiring a company – an objective opinion of value can play an important role in setting expectations and having a successful negotiation
  8. One or more owners are developing a retirement plan and need to establish a preliminary value of their shares
  9. The business is often the largest asset in an entrepreneur’s investment portfolio – understanding its value is essential to any good personal financial plan
  10. Owner(s) wants to enhance business value – a current valuation establishes a baseline and identifies opportunities for value enhancement
  11. Owners are creating a buy-sell agreement or purchasing life insurance
  12. Owners want to part ways and need an independent valuation to determine the share price, because they can’t agree on price or their buy-sell agreement requires it
  13. The company is recapitalizing
  14. The company is converting from a C corporation to an S corporation
  15. The company (public or private) has acquired another company and needs to allocate the purchase price to all the tangible and intangible assets for financial reporting purposes in accordance with ASC 805
  16. The company has an employee stock ownership plan (ESOP) or incentive stock options
  17. The company has goodwill on its balance sheet and needs to test it for impairment in accordance with Generally Accepted Accounting Principles (GAAP)
  18. The company has stock-based compensation and needs to comply with IRC 409A and ASC 718
  19. The court, or one or more owners needs an independent valuation in support of litigation, or to avoid litigation
  20. The owners decide a capital call is required and one of the owners has become insolvent, triggering a buy-sell

Click here for more information on the different uses of business valuations.

Contact one of Exit Strategies Group’s business valuation experts to discuss a potential business valuation need, confidentially and at no cost.

Rising Interest Rates and Investment

Since July, the benchmark interest rate, the US 10-year treasury bond, has risen from 1.35% to over 2.55%. That’s a very big move in a short-period. Post-election day the rising rate trend accelerated. We saw a similar spike in 2013, only to see rates retreat. Is it different this time?

Valuation Building Block

Markets seem to believe that current rates are sustainable and can keep rising given the lower tax and infrastructure spending pronouncements coming from the new president elect. Interest rates are building blocks in asset pricing. Generally, when rates change business, individuals, and investors will re-examine their assets and shift them around to reflect their risk and return preferences. The expectations for changes in asset prices can take on near-term speculative fever: “Wait, I need to buy before it gets more expensive!” or “Wait, I need to sell before this thing tanks!”

Stability vs return; fear vs. greed (the two emotions that drive market prices). What return can you expect on your investments – be they stocks, bonds, real estate, or a business? It’s seldom a simple calculation. If predicting financial markets were only about numbers, math professors wouldn’t need to profess!

Since the election, US equity markets have climbed and bonds prices have sunk. Bonds reaction to rising rates is predictable. Bonds are “fixed-income” meaning its coupon rate remains the same regardless how interest rates move; however, when rates rise bonds lose market value because newly issued bonds have higher coupon rates, hence more value to you.

Will the Trump rally continue its ascent? Investors will eventually begin the stability vs. return tug of war. The Federal Reserve announced its intention to raise rates three times in 2017. This may or may not materialize. However, if bond yields do rise, many will trade bond stability over higher, more volatile equity returns which could create less demand and lower prices for equity – both public and private.

Is the “New Normal” Fading?

The “new normal” camp sprang from the 2008-09 crisis. Proponents argued that an aging U.S. population and high debt levels would bring on a Japanese style deflationary environment; and that technology and automation would depress middle-class wages and reinforce lower price trends. In fact, wages have stagnated for over 10 years and rates have stayed historically low. The long-term average on the 10-year treasury bond is 5%; even with the rapid rate rise since July, we are still at half the long-term average.

On the other hand, lower prices spur consumption; and wages have started to show some improvement. Add some fiscal stimulus, a deregulatory minded White House, and government spending: Boom – Keynesian animal spirits will prevail!

However, a few wild cards worth considering: will political rhetoric be matched with real action that might incite a trade war? Will lower taxes and government spending on infrastructure spur growth without impacting the U.S deficit? Will financial reform of Dodd-Frank create the same mess that brought us to Dodd-Frank?

These type considerations will impact our domestic economy and the business environment. Low rates have helped prop up equity valuations, made real estate more affordable, and allowed businesses to lower their capital costs. Rising rates may create a headwind.

Risk of Return

Indeed, rate increases mean the cost of capital is going up. We business appraisers use the “build-up method” which begins with the US Treasury rate and “builds up” a required rate of return based upon various risk factors. If the rise in rates is accompanied by higher growth in revenue and profit, valuations can remain high. However, if rates climb, growth stagnates, or inflation eats into profits, it most likely will have a downward push on business value (both public and private markets).

Why is That Information Needed?!?

When we begin a business valuation project the first thing we do is provide an extensive document request list. A week or two into the analysis, we send a customized questionnaire to help us understand the business in appropriate depth. Our questions are designed to understand the facts and circumstances of your business well enough to develop a reliable opinion of value. To the extent we can, we try to streamline and tailor our requests so as not to overwhelm the client.

Most clients trust that we have a method to our madness and dutifully respond to each request and question. Sometimes however we get comments like: You asked for that before! Why do you need that? What does that have to do with value? So and so didn’t ask for that.

It’s an investigation, not an interrogation.

A key fact in most privately held businesses is that owners run personal expenses through the business. We ask about these for several reasons. For starters, a buyer would want to know the core expenses and cash flow of the business; they aren’t usually interested in paying for your kid’s health and auto insurance and cell phone bill. Second, when we add these expenses back, it increases the value of the business. Lastly, and very often overlooked, when owners evaluate post-exit income they often use flawed inputs to forecast income needs.

Case in Point:

On a recent exit plan an owner told me he thought his business was expensing $30,000 in perquisites annually. After we investigated, the actual amount turned out to be closer to $80,000. And that’s pre-tax. To replace that $80,000 after he exits the business, he would need around $120,000 in pre-tax income. That’s a $90,000 annual difference from his guesstimate. Inflation adjust for a 25-year retirement plan, and it produces a very large spending shortfall – or a big change in lifestyle. Isn’t that worth discovering today rather than when you run out of money 5 or 10 years into retirement?

And, no, we are not IRS agents!

This example illustrates why we ask a lot of questions. There are many more areas of your business that we need to investigate. Short-circuiting the valuation process only compromises the result and leads to poor decisions. A reasonably thorough analysis by a qualified valuation expert on the other hand produces a result that can be relied upon to make the best decisions for you, your shareholders and your family.

Fair Market Value — is it really fair?

In the business valuation profession, one determines Fair Market Value through analysis of the company and its management structure, the industry in which it participates, economic conditions and trends present in the industry, competitive environment, and any other factors that help to define the risk of investing in the enterprise. This analysis of risk is what many in the appraisal profession term as the subjective part of the valuation analysis, or “the art” of appraisal analysis.

The other part, which is the “science” component, is the financial analysis of the company. A proper financial analysis includes looking at the historic income statements, balance sheets and financial ratios to identify trends and see how the company performs relative to its peers in the industry. The next step is to normalize these financial statements to remove non-operating items, non-recurring items, and to adjust the compensation and perquisites of the owner to market rates (also known as control adjustments).

When these analyses are completed, the analyst usually determines a base year sales, earnings and cash flow forecast to capitalize (income approach) and apply market-derived multiples (market approach) to obtain indications of value. The last step in the process is to reconcile the various indicated values into a conclusion of value based upon the analyst’s confidence level in each of the methods used in the analysis.

I regularly appraise small businesses ($1 to 10 million revenue) for SBA 7(a) business acquisition loans, where the buyer and the seller are usually individuals or families. In doing this work I see the transactions that made it through the lender’s screening process, and I see the original asking price and the actual price paid. In most of these deals a business broker did a good job helping the seller set and achieve a fair price. Successful business brokers undertake the same steps that I outlined above to advise their clients before the sale.

I also see some of the deals rejected by lenders and I get to dissect past deals that no lender or appraiser ever touched. What I have observed is that sellers who sell a business on their own or work with a broker who short cuts the valuation process, often end up frustrated. They either leave money on the table, or end up financing most of the transaction and don’t get paid, or they waste valuable time and energy trying to sell for an unreasonable price.

When this sort of thing occurs the price paid or offered usually did not equate to Fair Market Value.

And sellers understandably have a difficult time evaluating brokers because they have no training or experience in this area.  Like any major financial transaction, we usually receive more in the end when we rely on qualified and experienced advisors from the very beginning.

For further information or to discuss a current need, Email Bob Altieri, CBA, or call him at 530-478-9790.