EBITDA explained

Features - Finances

It’s not alphabet soup. It’s a no-fluff number that tells the story of what your company is really worth.

November 28, 2016
Kristen Hampshire
© Chrishowey | Dreamstime

What’s your business really worth?

This is a question every owner should ask, whether or not selling is the plan. The operation you dedicate your time, resources and energy to growing is likely the greatest asset in your life. But how “great” is it, really, when you’re talking dollars and cents?

Fact is, there’s a significant value gap between a business that funds a comfortable lifestyle and one that can fetch a favorable price at the deal table. “A business should be built to sell,” says Tom Fochtman, president of Ceibass Venture Partners. “Whether or not you want to sell, let’s have it be the best operating company that it can.”

Enter a financial term that helps you get to the bottom of that value question: EBITDA, or earnings before interest, tax, depreciation and amortization. If this is the first you’ve heard of EBITDA, you’re not alone in the industry.

EBITDA is used to compare companies’ profitability because it takes out financing and accounting decisions. It removes debt, capital and tax effects by adding back interest and tax to earnings. Sound confusing? Basically, EBITDA is a measure of a company’s operating performance.

Most importantly, EBITDA is the basis of many M&A transactions, and understanding your adjusted EBITDA (removing from the equation owner “add-backs” like a spouse’s vehicle or an exorbitant owner’s salary) provides a true picture of how a company is actually doing and what its earning potential could be.

“As a small business, there are so many things you can take on as expenses that are not ‘operational expenses’ critical to running the business,” says Jim Huston, president of J.R. Huston Consulting. “When a consultant goes in to evaluate the business, they take into account these ‘adds’ and ‘deducts.’ The EBITDA is basically looking at a financial statement and P&L and making adjustments to bring it in line with fair market value, or legitimate operating costs.”

So why should you know your EBITDA? In many ways, it’s the “get real” number. EBITDA takes out the fluff – the extras that a buyer wouldn’t pay for – and leaves you with a number that can be used as a platform for growth. Once you know your EBITDA, you can see how reducing spending and improving efficiency can improve the value of your business. It shows how a company that’s operating with a value-minded approach can ultimately walk away with a lot more cash than one that uses the business as a vehicle for funding life’s expenses.

EBITDA at work.

Let’s play out an EBITDA scenario here. A company does $1 million in sales and the net profit is 10 percent before tax, depreciation and amortization. You consider “adds” and “deducts.” For example, the owner’s salary is $200,000 when it should be closer to $60,000 (what a buyer would pay for), and the spouse’s car is $5,000 a year – another add-in.

After those extras are “normalized,” you get a number – say, $150,000 of EBITDA.

Next, you apply the EBITDA multiple. This metric is used to measure a company’s cash return on investment. The ratio is a modification of operating and non-operating profits compared to market value of a company’s equity plus its debt. So, if we apply a five-times multiple to $150,000 EBITDA, the company’s value to a buyer is about $750,000. (Landscape multiples range from four on the low end to seven on the high end.) 

Value varies significantly depending on how a company performs. Fochtman illustrates this example: A company with $8.5 million in revenue has a five-year track record of 23 percent annual profit and renewal rates of 95 percent and higher. Its EBITDA is $2.4 million with a 6.1 multiple. That business is under contract for $14 million. (That’s a significant gain for the owner.)

“Companies are selling for four to seven multiples, which means if you have an EBITDA of $1 million you will get $4 to $7 million for it,” Fochtman says. “But, that depends on how good your company is.”

EBITDA in the landscape industry is driven by high renewal rates, low workers’ compensation modification rates, a strong management team and those operational efficiencies that increase revenue and profitability. “All of these things cause a company to sell for a higher multiple of EBITDA,” Fochtman says.

Teasing out the extras.

All of the add-ins a company pools into its financial picture can make all the difference in its value at the time of sale. “Adjusted EBITDA takes into account all of the owner add-backs, and all owners have them at some level,” Fochtman says.

Typical add-backs include: a large owner’s salary and year-end bonus, lawsuits and insurance claims, one-time professional fees, excessive inventory (parts, materials), family members’ wages and benefits when they do not play an active role in the business, repairs and maintenance. Consider all of those extras (and then some). Like, how about the week of vacation added to a two-day business conference?

If a buyer comes to the table, he or she will not place value on these expenditures.

So consider what expenses exist because you yourself own the business. Those are the expenses that must be normalized. “Things like funding an owner’s retirement plan will go away when you sell, and a new owner will not pay for a $75,000 pickup truck rather than a $45,000 truck,” Fochtman says. “If you’re paying yourself $300,000 a year when you’d hire someone else to do your job for $150,000, you have to normalize the $150,000. All of this goes back on top of that EBITDA number.”

“As a small business, there are so many things you can take on as expenses that are not ‘operational expenses’ critical to running the business.” Jim Huston, president of J.R. Huston Consulting

Some good news for owners in the landscape industry is that depreciation is put back into EBITDA. “Depreciation is a non-cash event that helps you,” Fochtman says. “It lowers your profit number, which in turn lowers the tax you will pay. This is a big deal in the landscape industry because we have lots of trucks, trailers and equipment. So, depreciation can be your friend.”

What drives multiples.

The type of landscape company you’re running plays into what multiple your company can get. A service-based landscape company with recurring revenue through maintenance accounts will be valued higher than a construction-based firm where sales are tied to the owner, Huston points out.

Fochtman says another reason that design/build firms tend to not hold value like other types of landscape businesses is because accounts are largely residential. “Then, it becomes, how much will a buyer pay for residential install backlog?” he says.

On average, a maintenance company is worth roughly $0.35 for every dollar of sales, Huston says. That means a $1-million company is valued at about $350,000 plus hard assets like equipment and inventory. However, some companies do sell for $0.50 to $1 of revenue – and more. Fochtman refers back to the example of the $18.5-million company under contract for $14 million, and another $8-million firm he’s representing that is under contract for $13.7 million. “Landscape maintenance companies of any size are being sold for (various multiples) of adjusted EBITDA,” he says.

Huston notes that lawn care companies generally sell for 1-to-1, so a business with $1 million in sales will often sell for $1 million. “Irrigation service companies are usually worth $0.50 on the dollar, plus or minus any equipment,” Huston says.