The preparation for retirement is often accompanied by a wave of emotions. If you’re a business owner, it’s a time to take emotion out of the equation and think strategically. Even if you plan to sell your business to a longtime colleague or family member, it’s in the interest of you and that buyer to arrive at an accurate valuation.
You’ll encounter quite a few metrics to measure profitability. The most common among them is EBITDA (earnings before interest, taxes, depreciation, and amortization), which is a company’s net income as indicated on the income statement plus adding back interest, taxes, depreciation, and amortization.
To some investors, EBITDA is just an accounting metric that doesn’t show true operating performance; others think it’s the only metric that matters. It’s probably somewhere in between those extremes, but it’s nevertheless a concept in which you need to be confident for the sake of your small business’s marketability in a sale.
The Merits of a Metric
The argument against EBITDA is based on the truth that you can’t put EBITDA in your personal checking account — you can only put cash in your checking account. And to get cash into your checking account, you need to pay interest on your loans, pay your taxes, and outlay for capital expenditures. It’s a good argument.
The problem is, it ignores that what one owner pays for “ITDA” may be different from what another owner pays. When valuing any company, EBITDA represents a starting point that allows you to calculate the interest, taxes, and capital expenditures you would pay if you owned the business.
For instance, the way you manage your business could change the amount you pay on your taxes. Will you allocate more toward management salaries? Will you leverage the business and be able to write off additional interest? What does your corporate structure look like? If it’s a C corp rather than a pass-through LLC, under the current tax laws you would pay 21% on federal taxes as opposed to facing personal income tax rates that currently go as high as 37%.
Another common school of thought revolves around depreciation.
Specifically, it’s important in determining value because it ultimately falls on a new business owner to replace depreciated assets. This is true, but it’s also more nuanced.
Asset value will vary depending on the method used to account for depreciation, as will the useful life of the true asset and the amount you’ll have to pay to replace it. Again, if EBITDA is there from the start, you can then add on maintenance capital expenditures to properly assess a business’s true cash flow power. And valuations are all about cash.
The impact of amortization can vary significantly as well. If you purchase a business as an asset sale, your company may have its own goodwill figure that amortizes over a different length of time, which comes with tax implications. EBITDA brings cash flow down to a standard value, and a buyer can add on the hypothetical values that would exist after purchasing the business.
The common thread is that EBITDA is an invaluable building block of a business’s valuation. If you can sustainably improve your small business’s EBITDA, the value of your business will increase for the foreseeable future.
Maximize Your Value
Though cash is king, plenty of factors can affect a company’s cash flow. EBITDA is at the base of it all. Many businesses sell for a multiple of EBITDA, which can be a more valuable metric than seller’s discretionary earnings. It can tell an investor or buyer what it would take to own the business, including the management cost.
Considering how emotional a process selling a business is, it’s beneficial to have standardized figures like EBITDA on hand. It’s a reasonable tool that can help keep both parties — business and buyer — on the same page. Here are a few ways to maximize your company’s EBITDA and showcase its full value:
#1. Make the earnings as pure as possible.
There are a lot of practices that can make it hard to maximize your earnings. For example, if you’re in the habit of running personal expenses through your business, you’ll struggle to calculate the earnings part of EBITDA.
Likewise, if you consistently invest in the company to drive growth through capital expenditures, then you’ll have to consider how much growth is tied to your spending. Will it come to a halt when capital expenditures slow down? If not, then you have true free cash flow.
On the other hand, if those capital expenditures are necessary to maintain cash flows, then they turn into maintenance capital expenditures. Although it doesn’t impact EBITDA, it will influence your company’s true ability to generate cash flow, and a buyer will have to think about adding those expenditures back.
Institute capital investments now to increase cash flow. The result could be earning two to five times that cash flow number later on in a sale. That, in itself, could end up becoming a significant ROI and boost for your small business.
#2. Take on debt to finance new investments.
Buyers won’t consider interest payments when valuing your company. Use an influx of fresh capital to supercharge cash flows, then get a multiple in the sale of those cash flows and use the proceeds to pay off the debt.
Just don’t overdo it. Rather than being a positive thing, 100% growth can actually show instability in the business, which naturally makes most buyers nervous. Find a nice middle ground that allows you to build an EBITDA that accurately conveys your small business’s current health and attracts viable potential buyers by being sustainable.
#3. Cut costs and look for recurring revenue.
Try to determine the current return on all of your existing investments. If certain expenses aren’t generating a required return, it may be time to rethink them. Any expenditure not generating short-term sales or building long-term value for customers should be evaluated closely.
Pay special attention to potential recurring revenue sources, which will generate gross income for a new owner as soon as the deal is finished. Build recurring revenue streams to win lots of new business in the years and months leading up to your exit. This will boost your EBITDA and give potential buyers confidence that they’re taking the reins of a thriving business.
If you’re a small business owner, the sale of your business will be a big part of your retirement plan. Attempting to assess the true value of your business can undoubtedly be stressful, but EBITDA gives you a solid foundation upon which to base your negotiations.
Are you a retiree who has experience selling a business? Are you planning a sale or currently in negotiations? Share your experience below.