Money is King. These three words mean everything. This is especially true in M&A transactions, which are primarily ‘for the money’. In this context, the valuation of a company being sold, i.e. the way of setting the share price and any post-purchase adjustments, is crucial.
EBITDA
The fundamental measure of a company’s value, most often used in M&A transactions, is EBITDA which in a nutshell shows the profitability and liquidity of a business, i.e. the cash flow achieved or achievable.
The choice of EBITDA as a measure of the price of shares to be sold allows the value of a company to be easily calculated and adjusted according to objective criteria.
Briefly, EBITDA is defined as:
- Earnings (E) – revenue minus operating costs
- Before (B) – the following cost items are not costs deducted from company revenue:
- Interest (I) – the cost of a company’s debt financing
- Taxes (T) – income taxes paid by a company
- Depreciation & Amortisation (D+A) – write-offs that reduce the value of selected assets of a company for accounting purposes, rather than for actual costs incurred by the company
Interest, which represents the cost of a company’s debt financing, income taxes and accounting depreciation & amortisation do not reduce its valuation but, on the contrary, ‘add to the bottom line’. This is because all these elements (I, T, D&A) can change completely or substantially after a transaction and are therefore not treated by buyers as being permanently linked to the business.
In other words, the cash a company spends on financial interest, income taxes and depreciation & amortisation is not deducted from its revenue. In fact, each of these items (I, T, D&A), which are demonstrated as ‘expenses’ in company accounts, may be treated quite differently by a buyer than by a seller prior to a transaction.
For example, financial interest may ‘disappear’ as a result of the repayment of company loans, which is common at the closing of a transaction.
This is because, in most cases, a buyer will require that a company’s existing financial debt be repaid by the company itself or by a seller, either before or at the time of closing.
The same applies to tax liabilities. A new owner may reorganise a company, resulting in a taxation change and lower tax paid.
The depreciation & amortisation of fixed assets and other selected assets of a company are treated in a similar way. These are not real operating costs and do not need to be continued after a transaction. Therefore, when calculating EBITDA, the above items are not deducted from company revenue.
Multiples in M&A transactions
EBITDA alone is not sufficient to determine the share sale price. It is also necessary to apply an appropriate multiple, i.e. a multiple of the annual EBITDA value. The size of the multiple depends, among other things, on the sector in which a particular company operates, its sales and its EBITDA.
Higher multiples are applied to companies with higher revenues.
For example, if a buyer agrees to pay the price set at 10 times EBITDA, where EBITDA is calculated for a given financial year, a company will present this value to the buyer, taking into account the assumed investment horizon and the expected payback period.
The absence of a multiple would result in the sale price, set as one year’s EBITDA, being disproportionately low compared to the true value of a company, understood as the potential for the company to deliver EBITDA at a similar or higher level in subsequent years, with its buyer being a ‘beneficiary’ of the company’s EBITDA growth.
Adjusted EBITDA
Standard EBITDA is also insufficient to determine the share price, as certain allocated costs included in the calculation of standard EBITDA should be excluded when determining the true (objectified) value of a company.
These include, in particular, one-off (extraordinary) costs resulting from completely exceptional situations, which should therefore not be allowed to unduly prejudge the value of a company.
Litigation costs, for example, are an extraordinary expense not treated as a fixed, recurring cost of a company affecting its valuation.
Personal expenses paid out of company funds are treated in a similar manner. A shareholder paying for their holiday from the company account is unlikely to be a normal business expense and also one unlikely to be continued by a new owner, especially if it is a company.
Similarly, Adjusted EBITDA does not include any non-recurring revenue that is atypical for a company, such as compensation payments or other similar but infrequent transactions.
To avoid problems with the calculation of Adjusted EBITDA, transaction documents should accurately describe the types of costs and revenues by which a company’s valuation will be adjusted.
Each M&A transaction requires an appropriate approach and level of effort to establish the valuation of a company and the mechanism for its potential adjustment.
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