Can’t Get Enough of EBITDA? Meet Value Adjusted EBITDA and Add-Backs!
In our previous article, “EBITDA—A Guide for the Uninitiated”, we explored the fundamentals of Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) and its crucial role in mergers and acquisitions.
We explored how this financial metric provides valuable insights into a company’s operational performance, cash flow, and overall value.
However, in M&As—particularly when it comes to dental and healthcare practices—there’s another layer to consider: Adjusted EBITDA.
This refined metric and its companion concept of ‘addbacks’ play a pivotal role in providing a more accurate picture of a business’s true financial health and potential.
Whether you’re a practice owner considering an exit strategy or a potential buyer looking to make an informed investment, grasping the nuances of Adjusted EBITDA and add-backs can significantly impact your decision-making process.
In this article, we’ll build upon our previous EBITDA discussion to explore:
- What Adjusted EBITDA is and why it matters
- The concept of add-backs and their role in M&A valuations
- Common types of add-backs (and even negative add-backs)
- The importance of scrutiny in the add-back process
- How these adjustments can affect deal valuations
- Best practices for sellers in presenting Adjusted EBITDA
So, let’s roll up our sleeves and dive in!
What Exactly is Adjusted EBITDA?
While EBITDA provides a useful snapshot of a company’s operational performance,
Adjusted EBITDA takes this concept further, offering a more nuanced and often more accurate picture of a business’s true earning potential.
Put simply, adjusted EBITDA is a refined version of standard EBITDA that considers non-recurring, irregular, or discretionary expenses.
It’s an attempt to normalise a company’s earnings by eliminating factors that may not reflect the ongoing operational reality of the business.
Why Use Adjusted EBITDA?
The primary purpose of Adjusted EBITDA is to provide potential buyers with a clearer view of what the company’s earnings might look like post-acquisition.
It aims to present a more accurate representation of the sustainable, recurring cash flows a new owner could expect to generate from the business.
How it Differs from Standard EBITDA
While standard EBITDA focuses on removing the effects of financing decisions, tax environments, and accounting practices, Adjusted EBITDA takes into account additional factors that might be unique to the current ownership or represent one-off events.
For example, standard EBITDA might include the owner’s salary, which could be higher than the market rate.
Adjusted EBITDA would add back the portion of the salary that exceeds the market rate, providing a more accurate picture of the business’s profitability under new ownership.
Why Adjusted EBITDA Matters in M&A Valuations
In the context of mergers and acquisitions, particularly in the dental and healthcare sectors, Adjusted EBITDA has become the go-to metric for several reasons:
Comparability
Adjusted EBITDA allows for easier comparison between different practices, even if they have varying ownership structures or have experienced unique events.
Future Potential
Adjusted EBITDA better indicates the business’s future earning potential under new ownership.
Valuation Basis
Many M&A deals are priced as a multiple of Adjusted EBITDA, making it a crucial factor in determining the final sale price.
Synergy Identification
For strategic buyers, Adjusted EBITDA can help identify potential synergies and areas for improvement post-acquisition.
Crucial Concept
Understanding Adjusted EBITDA is crucial for buyers and sellers in the M&A process.
For sellers, it’s an opportunity to present the business in the best light by highlighting its true earnings potential.
Meanwhile, for buyers, it provides a more accurate basis for valuation and helps identify potential areas for value creation post-acquisition.
However, it’s important to note that while Adjusted EBITDA can provide valuable insights, it should always be considered alongside other financial metrics and subjected to thorough due diligence.
In the next section, we’ll look at the concept of ‘addbacks’, which form the basis of these EBITDA adjustments.
Understanding Add-Backs
At the heart of Adjusted EBITDA lies the concept of ‘addbacks’. These are the adjustments made to standard EBITDA to arrive at a more accurate representation of a business’s earning potential.
What is an Add-Back?
Add-backs are expenses or losses added to a company’s EBITDA to normalise earnings. These are typically costs considered non-recurring, discretionary, or not necessary for the ongoing operation of the business under new ownership.
The term ‘add-back’ comes from the process of literally adding these expenses back to the EBITDA figure, thereby increasing the earnings number.
However, it’s worth noting that some adjustments can be negative, effectively reducing EBITDA.
Add-Backs and M&As
The primary purpose of addbacks in M&A is to provide a clearer picture of what the business might look like under new ownership. They aim to:
Normalised Earnings
By removing unusual or one-time expenses, addbacks help create a more stable and predictable earnings figure.
Reflect Future Performance
Addbacks can help project the business’s performance going forward, assuming certain expenses won’t continue under new ownership.
Highlight True Profitability
By adding back discretionary expenses, the true profit potential of the business can be more accurately represented.
Facilitate Comparisons
Add-backs can make it easier to compare different businesses like-for-like, even if they have different ownership structures or have experienced unique events.
How Addbacks Affect Valuation
Addbacks can have a significant impact on the valuation of a business in an M&A transaction:
Direct Impact on EBITDA
Each pound added back directly increases the EBITDA figure.
Multiplier Effect
Since many dental and healthcare practices are valued based on a multiple of EBITDA, every pound added back could translate to several pounds in the final valuation.
For example, if a practice is valued at 5x EBITDA, a £10,000 add-back could increase the valuation by £50,000.
Negotiation Tool
Addbacks often become a crucial point of negotiation between buyers and sellers. Sellers naturally want to maximise addbacks to increase valuation, while buyers scrutinise each addback carefully.
Risk Assessment
The nature and extent of add-backs can influence a buyer’s perception of risk. A business with numerous or significant add-backs may be perceived as riskier or less stable.
It’s crucial to note that while addbacks can significantly boost a practice’s valuation, they must be justifiable and stand up to due diligence. Overreaching with add-backs can erode trust and potentially derail negotiations!
Common Types of Add-backs
In dental and healthcare practice M&A transactions, some categories of addbacks appear frequently. Understanding these can help buyers and sellers navigate the valuation process more effectively. Let’s explore the most common types of Add-backs:
- Non-Recurring Items
These are expenses that are not expected to continue under new ownership or are considered one-off events:
Legal Settlements and Costs
- Example: A practice that paid £50,000 to settle a one-time malpractice claim.
- Rationale: This expense is unlikely to recur and therefore doesn’t reflect the ongoing operational costs of the practice.
One-time Consulting Services
- Example: A £30,000 fee paid for a practice management overhaul.
- Rationale: This significant consulting expense is not typically an annual occurrence.
- Owner-Related Adjustments
These add-backs relate to expenses that are specific to the current owner and likely won’t continue under new ownership:
Above-Market Owner Compensation
- Example: The owner-dentist pays themselves £250,000 annually, but the market rate for a dental practice manager is £150,000.
- Rationale: The £100,000 difference could be added back, as the new owner might hire a practice manager at market rate.
Owner Perks
- Example: The owner’s spouse is on payroll for £40,000 but doesn’t work in the practice.
- Example: The practice pays £15,000 annually for the owner’s luxury car lease.
- Rationale: These expenses are personal benefits to the current owner that don’t contribute to the operational performance of the practice.
- Other Common Addbacks
Charitable Donations
- Example: Annual £5,000 donation to a local charity.
- Rationale: While admirable, charitable giving is often at the owner’s discretion and may not continue under new ownership.
Start-Up Costs for New Services
- Example: £25,000 spent on marketing and equipment for a new cosmetic dentistry service.
- Rationale: These are one-time costs associated with expanding the practice’s offerings.
Excess Rent on Owner-Occupied Property
- Example: The practice pays £10,000 per month in rent to a property company owned by the practice owner, but the market rate is £7,000.
- Rationale: The £3,000 monthly difference (£36,000 annually) could be added back.
Negative Add-backs
It’s important to note that not all adjustments increase EBITDA. Some scenarios require negative add-backs:
Below-Market Owner Compensation
- Example: An owner-dentist who pays herself only £50,000 annually to minimise tax liability.
- Rationale: A negative add-back might be necessary to reflect the true cost of hiring a full-time dentist at market rates.
Deferred Maintenance
- Example: A practice that has put off necessary equipment upgrades to boost short-term profits.
- Rationale: A buyer might insist on a negative add-back to account for upcoming necessary expenses.
The Importance of Scrutiny in Add-Backs
Careful scrutiny of add-backs is crucial in M&A transactions. Each add-back should be verified, substantiated, and logically justified.
Key considerations include:
- Documentation: Clear financial records should support all addbacks.
- Consistency: Expense treatment should be uniform across financial periods.
- Materiality: Focus on addbacks that significantly impact EBITDA.
- Future Relevance: Ensure the expense won’t recur under new ownership.
- Business Necessity: Verify if the expense is truly non-essential.
- Market Norms: Compare expenses to industry standards.
Questionable addbacks include recurring ‘one-off’ expenses, overstated owner contributions, or aspirational cost-cutting. Due diligence, involving financial review, operational assessment, and market comparison, is vital in validating addbacks.
Proper scrutiny ensures a more accurate valuation, leading to fairer deals and a clearer understanding of a practice’s true earning potential.
The Impact of Addbacks on Deal Valuation
Addbacks can significantly influence the valuation of a dental or healthcare practice in M&A transactions:
Direct EBITDA Impact
Each pound added back directly increases the EBITDA figure.
Multiplier Effect
With practices often valued at multiples of EBITDA, even small addbacks can substantially increase the final valuation. For instance, a £10,000 add-back could increase the practice value by £50,000-£100,000, depending on the multiple.
Negotiation Leverage
Addbacks often become key negotiation points. Sellers aim to maximise justifiable add-backs, while buyers scrutinise each one carefully.
Risk Assessment
The nature and extent of addbacks can influence a buyer’s perception of the practice’s stability and risk profile.
Future Performance Indicator
Well-justified addbacks can highlight potential areas for improved profitability under new ownership.
Comparative Analysis
Addbacks allow more accurate comparisons between practices with different ownership structures or recent one-off events.
In Conclusion
Understanding Adjusted EBITDA and addbacks is crucial. These concepts provide a more accurate picture of a practice’s true financial health and potential, benefiting both buyers and sellers:
- Adjusted EBITDA offers a normalised view of earnings, reflecting potential performance under new ownership.
- Addbacks can significantly impact valuation but require scrutiny and justification.
- Identifying and validating addbacks demands a delicate balance between maximising value and maintaining credibility.
Talk to the Experts
Navigating these complex financial concepts can be challenging, but it’s essential for achieving fair and successful M&A transactions.
At Pluto Partners, we specialise in dental and healthcare M&A, with deep expertise in financial analysis, including Adjusted EBITDA and addbacks. Our team can help you:
- Accurately value your practice or acquisition target
- Identify and justify appropriate add-backs
- Navigate complex negotiations with confidence
- Ensure a smooth, transparent, and fair M&A process
Contact Pluto Partners today for a confidential consultation on maximising value and achieving your practice transition goals.
Christina Diamanti
Abbey Road Dental Owner
A huge thank you to Max for all his help! I would not have been able to buy my practice without his professionalism, expertise and enthusiasm. He was always there to give support and advice and checked in with everyone involved at all times to make sure everything was running smoothly!