How Unrealistic EBITDA Addbacks Impact Buyer Negotiations

You never get a second chance to make a first impression! It has been said that it takes the average person about seven seconds to form an opinion of you that never changes.  The same principle applies to a potential buyer of your business (although it is likely to take a little longer than seven seconds!).  In this blog article, we outline some key considerations when sharing financials with a prospective buyer and how EBITDA addbacks impact a buyer’s viewpoint on value.  Addbacks are positive or negative adjustments to earnings that aim to reflect the business’s “maintainable earnings” for a new owner.

From our buy-side advisory engagements, we often see two scenarios. 1) where no addbacks have been included, and the internal or audited financial statements, or sometimes even the tax returns are the first numbers a buyer sees, or 2) where the addbacks are so broad and all-encompassing, that they negatively impact the buyer’s first impression of the business.  The risk for scenario 1, is that you may miss out on a non-recurring expense that is not reflected in a preliminary offer. It most often happens when the seller is not actively selling the business and is simply responding to an interesting inquiry.  The risk for scenario 2, is perhaps more serious.  It is natural that the seller wants to present the business in its most favourable light to get the best offers. The issue, however, lies more in the pending consequences during the negotiation stages that can lead to a disappointing outcome.

With unrealistic addbacks, your best buyers may now view everything you share throughout the negotiations with a more sceptical lens based on their perceived first impression of your credibility.  The negotiation process can be thought of as a balance of power, that changes as the process progresses.  It is critical during the first impression stage, that you present yourself, your business, and your financials with credibility.  That means EBITDA addbacks with clear justification and documentation that can be verified and articulated with well-thought logic around your assumptions backed by real facts.

Owner benefits are the most obvious, and often the easiest addbacks to identify and justify.  While some private companies have very “clean” financials, others have the country club expenses, cottage maintenance, kid’s salaries and the owner’s home renovations embedded throughout the statements that need to be adjusted.

Including addbacks such as the full salaries for key owner/management may seem logical, if there are no plans to stay post-transaction.  However, from the buyer’s point of view, there will still be expenses associated with the business’s management.  Adjustments should be based on the business’s needs and valid assumptions on market salaries, by using outside sources, such as salary surveys for the industry and/or region.  If the company is owned by an affiliated company that provides administrative, accounting, IT, or banking support, those also need to be included in an adjustment.

There are often other non-recurring expenses that should be added back but need to be clearly justifiable.  These are particularly important in rapidly growing companies and include additional or unusual expenditures on new hires, R&D, patent applications or advertising for example, where the benefits will accrue to the new owner.  It is tricky to convince buyers that these will not necessarily recur unless they can be clearly defined.

In order to get a deal to the finish line, addbacks will be thoroughly assessed by the potential buyer or buyers, and if a deal is to close, it will be based the buyer’s due diligence.  Addbacks are often reviewed by an outside firm, through a “Quality of Earnings” (QofE) review and a buyer may adjust any preliminary offers based on any material items that are discovered.  Given the increasing frequency in which a QofE is undertaken before closing, it is best to make an accurate estimate of the correct adjustments well before the QofE review, and ideally before any potential buyer sees any numbers.

In summary, the best approach to gain credibility and a good first impression with potential buyers, is to carefully and thoughtfully adjust EBITDA where the reasoning can be easily explained and justified.  Opening the dialogue with unadjusted financials leads to a potential missed opportunity to capture some value and throwing unrealistic adjustments at a buyer, just raises questions that are better left out of the negotiation process.  Adjusting EBITDA is just one of many steps business owners need to take to properly prepare for a sale of the business.

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