EBITDA and Adjusted EBITDA in Agency M&As

When preparing to sell your agency, understanding financial metrics is crucial. One key metric that often comes into play during M&As is EBITDA. However, as negotiations progress, you may encounter the concept of “adjusted EBITDA.” This blog will get into the specifics of these terms and their significance in the M&A process.

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a financial metric used to evaluate a company’s operating performance without the influence of financing decisions, accounting practices, or tax environments. EBITDA provides a clearer picture of a company’s operational efficiency and profitability.

The basic formula for EBITDA is: Net Income + Interest + Taxes + Depreciation + Amortization = EBITDA

EBITDA in the M&A Process

During M&A negotiations, EBITDA often serves as a starting point for valuation discussions. However, as talks progress, sellers may introduce the concept of “adjusted EBITDA.”

Adjusted EBITDA involves modifying the standard EBITDA calculation to account for unusual, non-recurring, or extraordinary items that may not reflect the true ongoing performance of the business. These adjustments aim to present a more accurate picture of the company’s earning potential to potential buyers.

Common adjustments might include:

1. One-time expenses (e.g., legal fees for a lawsuit)
2. Owner-related expenses that won’t continue post-sale
3. Extraordinary or non-recurring income or expenses
4. Costs related to discontinued operations

Sellers often propose adjusted EBITDA to highlight the company’s true earning potential. Some scenarios where this might occur include:

1. Recent Investments: If the agency has recently invested in new technology, talent, or marketing efforts that haven’t yet yielded returns, sellers might argue for adding back these expenses.
2. Non-Recurring Expenses: Costs related to one-time events, such as moving offices or rebranding, might be added back as they don’t reflect ongoing operational costs.
3. Owner Compensation: In smaller agencies, owners might draw higher-than-market salaries. Adjusting this to market rates can increase EBITDA.
4. Synergy Opportunities: Sellers might adjust for expenses that a buyer could eliminate post-acquisition, such as redundant administrative costs. 

The Danger of Aggressive Add-Backs

While adjustments can provide a more accurate picture of an agency’s potential, sellers should be cautious about proposing too many or overly aggressive add-backs, which is exactly what a buyer’s quality of earnings review is built to test. Here’s why:

1. Credibility Concerns: Excessive add-backs can make buyers skeptical about the seller’s integrity and the quality of the business. If a company appears to require numerous adjustments to look profitable, buyers may question its fundamental value.
2. Negotiation Complications: Each proposed add-back opens up a new point of negotiation. Too many can complicate and prolong the process, potentially jeopardizing the deal.
3. Valuation Impact: While add-backs aim to increase valuation, overly aggressive adjustments can backfire. Buyers may discount the adjusted EBITDA or apply a lower multiple if they perceive the adjustments as unrealistic.
4. Due Diligence Risks: Buyers will scrutinize each add-back during due diligence. If they find proposed adjustments unjustified, it could erode trust and potentially derail the deal.
5. Future Performance Expectations: Aggressive add-backs set high expectations for future performance. If the business fails to meet these expectations post-acquisition, it could lead to disputes or earn-out complications. 

Best Practices for Agency Owners

When considering adjusted EBITDA, agency owners should:

1. Be conservative and realistic with adjustments.
2. Clearly document and justify each proposed add-back.
3. Focus on truly non-recurring or extraordinary items.
4. Consider the buyer’s perspective and potential skepticism.
5. Work with experienced M&A advisors to strike the right balance. 

Conclusion

While adjusted EBITDA can be a useful tool in M&A negotiations, it’s essential to approach it carefully. The goal should be to present an accurate, justifiable picture of the agency’s earning potential, not to artificially inflate its value. At the end of the day, value is going to be “willing buyer, willing seller.” Presenting a clear, honest, and well-supported financial picture is the best way to achieve a successful and mutually beneficial transaction. How the proceeds get taxed is a separate decision from the price, and the deferral most sellers are sold is often already available without it.

To get a broader look at some other effective agency owner exit strategies, tune in to this episode of The Progressive Agency Podcast to hear more from our guest, David Tobin.