So let’s start with a history lesson; just how did the term EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) come to be bandied around by advisors looking to sell small owner managed companies?

Well EBITDA first came into use with what were called “leveraged” acquisitions in the 1980s and it was designed to give an indication of the ability of a target company to service its debt.  It was especially useful and it became popular with industries that had expensive assets where they would normally be written down over long periods of time.  For example, manufacturing companies with complicated production lines that would not be replaced quickly, would be ideal candidates for this method.

Like lots of techniques, once they gain some traction in use, often they become adopted “models” regardless of whether they are appropriate or useful – humans are inherently lazy and if an advisor can “copy and paste” a template he or she will do so.  So EBITDA is often quoted in the tech sector even when it’s completely inappropriate given the nature of their assets!

So why is this a problem?

There are two main reasons why it’s a problem for small business sales.  Firstly, the method is not an “approved “ method in formal accountancy practice, which means it can be “bent” between reporting years.  Secondly, it’s a common mistake to present EBITDA as representing cash earnings, so it might be relevant for profitability (with some heavy caveats) but no good for cash flow purposes – and worse still ignores the requirements for working capital and replacing old equipment, both of which can be significant.

So essentially, it’s an accounting gimmick, invented to create something of an illusion regarding a company’s earnings.  Now this is a BIG problem for the business owner, trying to understand what his business is really worth because he or she will rely on what they are told by external advisers like accountants, business brokers and sometimes lawyers.

In our experience, it’s especially common for business brokers to use the term because it can present a business at the highest possible price and their commission is usually tied to the selling price….you get the picture.

A better alternative, in our view, is for sellers to adopt a Price Earnings Ratio approach, which strips out the Corporation Tax that every profitable business has to pay anyway, and allows a fair and reflective multiple to true profit to be applied, in a transparent and honest way.

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