EBITDA is a simple, widely understood adjustment that can indicate cash flow when assessing value. This measure calculates expenses from the earning statement, calculating cash flow and value without adjusting for taxation, interest, and other environmental variables.
Normalizing EBITDA enables sellers to favorably present their businesses. It’s wise, however, to be cautious with the number of normalizing adjustments for owner’s perks that you charge to the business. Here are four of the most common adjustments, and a few words of caution for each.
Benefits of expenses that don’t normally affect profitability fit into this category. Some adjustments include, but are by no means limited to, moving costs, losses from discontinued operations, and insurance payouts. But some non-recurring expenses, including lawsuit settlements, can be red flags—such as when the business is in an industry rife with frivolous litigation. In such cases, the acquirer might deem the expense a normal, recurring one that must be accounted for in financial statements.
This is a broad category. It includes costs such as meals, travel, entertainment, discretionary bonuses, and personal insurance policies. Although all of these expenses can technically be normalized, this isn’t always best policy. A good rule of thumb is that costs not directly related to the business should not be charged to the business.
A few examples:
- Travel expenses may not always be directly related to business activities, so owners may be able to normalize these costs.
- Meals are generally ineligible for normalization, with some exceptions. For instance, expenses related to business sales, which are non-recurring and untied to normal business expenditures, but which are related to normal operations, can be normalized.
- Auto leases are acceptable sources of adjustments, since executives shouldn’t drive a car that leaves them embarrassed to meet a client. Many executives receive reimbursement for their cars.
- Entertainment is a vague category, making it a favorite target for owner perks. It should be directly related to business activities, but when there are exceptions, they can be normalized.
- Cell phones, personal insurance, and other perks are acceptable since they are not typically related to the owner’s involvement, and will likely not be present after the sale.
Large Family Salaries
Some owners gift family members with compensation packages that exceed what a similarly situated person would make in the same job. These expenses would disappear following a sale, assuming the acquirer switches to fair market wages. When this is the case, it’s fine to normalize these expenses.
Charitable donations are good karma that can usually be normalized. However, when a contribution is a sales or marketing expense—as when a business sponsors a golf tournament for a healthcare client—these deductions may not be normalized. Only when the contributions are disconnected from the ongoing nature of the business can they be normalized.
This should clarify a bit about how EBITDA works. From an ethical and sales point of view, improperly charging costs may save money, but could cost you down the road. Talk to your M&A advisor or personal accountant to get help addressing any concerns.