Adjusted or Normalized EBITDA: Equal Parts Science and Art

Adjusted or normalized EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a commonly used metric in M&A (Mergers and Acquisitions) transactions to assess a company's financial performance and to provide a baseline earnings metric upon which to apply a multiple when determining its enterprise value. The adjustments are added or subtracted from the actual EBITDA to better reflect the normalized earnings that would, or could, be expected under new ownership before any anticipated synergies or any changes to the strategic plan.

Sellers often provide potential buyers their view on adjustments for certain one-time or non-operational expenses to add back to EBITDA. However, determining the appropriate add-backs to include can be challenging, and different buyers may have different views on what qualifies as a legitimate add-back.

Here are some common and legitimate add-backs that seller should consider:

Non-recurring or one-time expenses: Expenses that are unlikely to occur again in the future, such as restructuring costs, severance payments, or legal settlements. One-time expenses could be related to a specific event, such as the acquisition of a new business, a significant investment in a new product, service, or technology or expenses related to a natural disaster. Expenses related to termination of leases or other operating contracts may also be legitimate one-time expenses that should be added to EBITDA.
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Consulting and other professional service fees:  Often business owners hire an M&A advisor to help them prepare the business for a sale and to represent them in a competitive process.  Any upfront fees paid by the seller can be added back.  There are also times when an outside consultant is used on a periodic basis that can often be considered a reasonable add-back.

Owner/management compensation: If the company's owners or executives are taking a higher salary than what many may consider the market rate, the portion of their compensation that is “above-market” can be added back to the EBITDA.  Sometimes, the owner-operator will be leaving post-transaction and the seller adds back their entire compensation.  This is only considered reasonable by the buyer, if the owner is collecting a salary but is not involved in any day-to-day activities or functions within the business (i.e. absentee owners).

Other expenses: Expenses that are not directly related to the company's core operations or expenses related to the owners that are non-operational, such as personal expenses or payment of premiums for owners’ life insurance policies.  Some expenses that could have been capitalized could be included here.  Often EBITDA is normalized to exclude other expenses and income related to the gain/loss on the disposition of assets, foreign exchange gains/losses, etc.

Non-arm’s lengths transactions: Expenses to related parties that are above or below market need to be added to (when above market) or subtracted from (when below market) from the Adjusted EBITDA.  This could include product discounts or preferred terms to affiliated firms, lease/rent costs for facilities with common ownership, etc.

There are numerous items that may or may not be legitimate add-backs such as lost/deferred revenue due to temporary price reductions or increases, or temporary changes in product purchasing and sourcing costs (cost increases, freight expediting, etc.).  There could also be one-time retention incentives, employee absence or severance costs, and/or re-hiring costs that increased total compensation expenses that may be legitimate EBITDA add-backs.

While add-backs can help adjust the EBITDA to provide a more accurate picture of the company's financial performance, it's essential to use them judiciously. Buyers may get frustrated and the seller may lose credibility if they add back too many expenses and overestimate its normalized EBITDA. Buyers may also question the legitimacy of add-backs that appear to be subjective or those that are not supported by documentation.

In summary, when considering add-backs in M&A deals, it's crucial to be transparent and consistent and provide detailed documentation to support the add-backs. For investors and lenders to accept these "add-backs" into their valuation and underwriting methodology, add-backs must be reasonable, well-documented and defensible. Buyers will appreciate a clear and reasonable approach to add-backs that accurately reflects the company's financial performance.