Understanding EBITDA in the Search Fund Context

By James A. Donellon, CPA, MSA
Gray, Gray & Gray, LLP

For search fund operators and entrepreneurs through acquisition (ETA), few financial metrics carry as much weight as EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). This metric serves as the foundation for business valuation, particularly in the lower middle market where most search funds operate. However, raw EBITDA figures rarely tell the complete story of a business’s true earning potential. This is where EBITDA adjustments come into play – a crucial yet often misunderstood aspect of the acquisition process.

EBITDA adjustments represent modifications to a company’s financial statements that aim to provide a more accurate picture of the business’s sustainable earning capacity. For search fund operators, understanding these adjustments is not merely an academic exercise but a practical necessity that can significantly impact purchase price, financing terms, and post-acquisition performance expectations.

The Purpose of EBITDA Adjustments

The fundamental purpose of EBITDA adjustments is to normalize earnings to reflect the business’s true operational performance by removing non-recurring expenses, owner-specific costs and accounting anomalies. When a searcher evaluates a potential acquisition, they’re not merely buying the business as it exists today – they’re investing in its future earning potential under new management and potentially new operational strategies.

For privately held businesses, particularly owner-operated companies in the lower middle market, financial statements often reflect the personal preferences and tax strategies of the current owner rather than optimal business operations. Certain expenses may be artificially inflated or understated, while owner benefits might be embedded within various expense categories. EBITDA adjustments help strip away these idiosyncrasies to reveal the business’s core economic engine.

Common EBITDA Adjustments for Search Fund Acquisitions

• Owner Compensation and Benefits
  Perhaps the most significant adjustment in many search fund acquisitions involves owner compensation. In smaller businesses, owners often pay themselves above or below market rates, depending on the business’s performance and personal financial needs. A proper adjustment normalizes this compensation to reflect what would be required to hire a professional manager to run the business.
  
  Additionally, owners frequently run personal expenses through the business, including travel, vehicles, insurance policies, cell phones and club memberships. These perquisites, while legitimate tax strategies for business owners, do not represent necessary business expenses under new ownership and should be added back to EBITDA.
  
  
• One-Time or Non-Recurring Expenses
  Expenses that are unlikely to recur under new ownership should be identified and added back to EBITDA. These might include litigation costs, expenses related to natural disasters or accidents, one-time consulting projects or costs associated with discontinued product lines or services. The key question to ask is whether these expenses are likely to repeat under normal business operations going forward.
  
  
• Family Member Compensation
  Many family-owned businesses employ relatives who may be compensated at rates that don’t align with their actual contributions to the business. Some may be overpaid relative to market rates, while others might work for minimal compensation or entirely without formal payment. Adjustments should normalize these arrangements to reflect arm’s length employment relationships.
  
  
• Facility Costs
  Real estate arrangements in privately held businesses require careful scrutiny. If a business operates from a property owned by the seller and pays below-market rent, an adjustment upward may be necessary to reflect true occupancy costs. Conversely, if the business pays above-market rent to a related entity, a downward adjustment would be appropriate.
  
  
• Deferred Maintenance and Capital Expenditures
  Businesses approaching a sale might defer maintenance or necessary capital expenditures to improve short-term profitability. Savvy search fund operators should identify these situations and adjust EBITDA downward to account for the catch-up spending that will be required post-acquisition.

The Art and Science of EBITDA Adjustments

While some EBITDA adjustments are straightforward, many require nuanced judgment and industry knowledge. What constitutes a truly non-recurring expense? What is a market-rate salary for the owner-operator in a particular industry and geography? These questions don’t always have clear-cut answers.

High-quality financial due diligence involves not just identifying potential adjustments but substantiating them with compelling evidence. Searchers must be prepared to defend their adjustment rationale to investors, lenders, and ultimately the seller during purchase price negotiations.

The most defensible adjustments are those that can be clearly documented and quantified. Bank statements showing personal expenses, compensation benchmarking data for similar roles and market-rate analyses for facility costs all provide objective support for proposed adjustments.

Common Pitfalls in EBITDA Adjustments

Search fund operators should be wary of several common mistakes when analyzing EBITDA adjustments. Overly aggressive adjustments can lead to unrealistic expectations about post-acquisition performance. Every dollar of “adjusted” EBITDA typically translates to multiple dollars of purchase price, creating a temptation to be liberal with add-backs.

Conversely, overlooking legitimate adjustments may cause searchers to pass on otherwise attractive acquisition opportunities. This is particularly true for businesses with significant owner perquisites or those that have experienced recent non-recurring setbacks that suppressed earnings.

Another frequent error is failing to consider the interdependence of various adjustments. For example, normalizing owner compensation might necessitate adding back certain benefits, but some of those benefits might need to be retained for a professional manager.

Post-Acquisition Reality Check

The true test of EBITDA adjustments comes after the acquisition. Searchers should develop a clear plan for how each adjustment will be realized under their ownership. Some adjustments, like eliminating owner perquisites, can be implemented immediately. Others, such as operational improvements or synergies, may take time to materialize.

Maintaining a bridge between adjusted EBITDA and actual post-acquisition performance helps searchers track their progress and explain variances to investors and lenders. This accountability is crucial for building credibility, especially for first-time search fund operators.

Taking a Strategic Approach to EBITDA Adjustments

For search fund operators, EBITDA adjustments represent more than a financial exercise – they are a strategic tool for identifying hidden value and potential operational improvements. When approached with rigor, objectivity and transparency, the adjustment process can reveal opportunities that might otherwise remain obscured in the financial statements.

The most successful searchers approach EBITDA adjustments with a balance of optimism and conservatism. They recognize the legitimate opportunities to normalize earnings while remaining grounded in what can realistically be achieved post-acquisition.

By mastering the nuances of EBITDA adjustments, search fund operators position themselves to make better acquisition decisions, negotiate more effectively with sellers and set realistic expectations with investors and lenders – ultimately increasing their chances of long-term success in the entrepreneurship through acquisition journey.