When an acquiring company values a business they usually do this by multiplying EBITDA by a multiple. Often their goal is to try and reduce the amount of earnings that can be included in EBITDA and then pay as small a multiple as they can get away with, or that they can pretend is the industry average for the type of business they are buying.
I hear so many times the negotiator on the other side of the table say that they are calculating the multiple using this and that data, but I’ve seen these multiples vary so wildly that it really can only come down to one thing: how much they are willing to offer for the business. I recently noted that an agency was valued at 7 times EBITDA, while another one was only 4.5 times EBITDA, for all intents and purposes the two businesses were alike in every manner. The only thing that really separated them was that one business had an advisory representing them while the other, negotiating an exit for the first time and lacking in experience in what to ask for, could only rely on what they thought they might be worth.
Once we have separated the multiple from the equation, the other factor is EBITDA, and more importantly, keeping as much of it as intact as possible. Buyers will often try and make as many deductions from EBITDA as possible, some of these deductions are extremely reasonable while others are spurious at best. One of the most common adjustments made to EBITDA is for dividends paid out in previous years and this is perhaps the fairest. Why is your EBITDA adjusted for dividends? Shouldn’t the EBITDA include the full amount of dividend as a dividend is paid directly out of earnings after tax?
The reason EBITDA is adjusted for dividends
The reason for this is the way that most small businesses manage the tax affairs for the shareholders who work in the business. Often the shareholders will pay themselves a below the market salary that keeps them on the tax and insurance radar but not enough to put them over any tax thresholds and then pay themselves dividends that would make up a normal wage but pay a much lower tax rate. They can legally do this as a perk of being a shareholder AND an employee at the same time.
Once they have sold the business to new owners, although they will continue to be an employee of the business they will no longer be a shareholder and as they can no longer exploit this tax advantage their wages going forward would be removed at the point between Gross Profit and Net Profit where EBITDA is calculated after overheads have been removed. As the new salaries that the new owners are paying to the former owners is now reducing the EBITDA, they will want to reflect this in any calculations they make for the value of the company for previous years.
So for instance the previous year’s EBITDA may be £500,000, the directors are paying themselves £12,000 and taking a £108,000 dividend. There are two directors in the business and essentially they are paying themselves £120,000 each. As their £12k salary was deducted before EBITDA, we can add £24,000 back in, but we must then take away the two dividend payments of £108,000, totalling £216,000. Our calculation will look like this:
£500,000 + £24,000 – £216,000 = £308,000
So now we have an adjusted EBITDA which reflects a business where the two directors are paid as normal employees of the business and not as two cheap employees and two nicely paid shareholders. In a parallel universe the business would have paid the shareholders in this way as employees had they been hired to do the jobs they had been doing. So, the EBITDA now represents the parallel universe earnings of the company.
When adjusting EBITDA for dividends isn’t fair
There are a couple of occasions where this isn’t fair to deduct a full amount of dividends, in my opinion. The first case would be if the acquiring company is looking to drastically reduce the salaries of the owners in the future years. So for instance if our two shareholders agree to work in the business during their earn-out for a salary of £60,000 each as employees and pay normal tax, then EBITDA shouldn’t be reduced by £108,000 each, but by £48,000 each (EBITDA + £12,000 – £60,000). This leaves the former owners with a much fairer valuation for the business as they are expected to work for much less than they had done previously and so should benefit from their upfront payment or earn-outs being more substantial to support their current lifestyle.
The other occasion where this isn’t fair is where the owners of the business have been re-investing retained earnings into another investment vehicle. This is often property, where the owners of the business have been advised by their accountants or wealth management advisor to put their surplus cash somewhere sensible to generate more revenue for a separate property business, or in a pension pot of some kind. These exceptional payments should not be used to reduce the total EBITDA used for the valuation, rather the acquirers should accept that the director/shareholders are drawing a monthly wage that is made up of salary and dividends. This monthly dividend should be used to calculate the adjusted EBITDA total and not any annual bonus or exceptional dividend drawing re-invested elsewhere and should also be a base salary offered as employees in their new service contracts.
Negotiating valuations using EBITDA
In summary, when negotiating the valuations for your company, don’t be pushed by the acquiring party into an unreasonably low offer that is justified by “normal calculations” being made. There really is no normal negotiation, there’s lots of discussion as to why companies should be valued a certain way, but it seems to me that there is very little evidence backing up these valuations, either on by multiples side or any other adjustments. Acquirers pay what they can get away with, they are balancing what they can afford against what will keep the shareholders happy, especially where there’s an earn-out involved. Sellers should make sure that they’re comfortable with an offer, if they are working within the business post transaction then almost certainly they should work out what they could have earned using the business’s assets themselves during the same time frame as the earn out and then add a 1 or 2 times multiple on, as the seller will be helping build the business after the sale. Of course that needs to be balanced off against job security and other benefits are being offered.
Finally, always remember that a company is only worth what a buyer is prepared to pay. There is some alchemy involved in negotiating a deal, of course, but if a buyer can’t afford what you’re asking then no amount of negotiating will increase the offer. It may be that you will be more comfortable and confident in the outcome that you can expect if you use an advisory firm like Capital A when finding a buyer for your agency and negotiating the terms of the deal, please contact us here for some free non-commitment advice.