With a high level of merger-and-acquisition activity in the tree care industry, owners are naturally interested in what is driving all the activity and how it will affect their businesses. One term being bantered about is the EBITDA, a measurement of a business’s value. So what is your business’s EBITDA, and why should you care?

While an exceptional fleet may not add to the value of a business, replacing equipment can cause EBITDA to go up, as a result of lower repairs and maintenance costs. TCIA staff photos.

Business owners are naturally interested in understanding the value of their businesses – even if they have no intention of selling anytime soon, or maybe ever. This is especially true when you hear rumors of competing and seemingly similar businesses selling for astronomical numbers, which may or may not be true and certainly requires some context.

In general, valuation can be thought of as the result of expected future cash flows adjusted for the risk and other qualitative factors associated with those future cash flows.

What is EBITDA?

EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is a commonly used measure of cash flow from a business and is often used in business valuation. EBITDA removes noncash expenses for the formula, and removes the impact of financing decisions.
How do you calculate EBITDA? Here is the basic formula:
Start with: Net earnings
(accrual basis)
Add: Interest expense (net of interest income)
Add: Income taxes (federal, state and local)
Add: Depreciation expense
Add: Amortization expense
Deduct: Gain on sale of assets
Add: Loss on sale of assets
Add: Nonoperating or
nonrecurring expenses
Deduct: Nonoperating or nonrecurring income
Equals: EBITDA
Add or deduct: Normalizing adjustments (“add-backs”)
Equals: Adjusted EBITDA

Explaining these terms

Some of the elements of EBITDA are straightforward and appear on your income statement. Other elements require additional explanation.

The EBITDA formula leaves property and equipment out, but you can be sure that potential buyers don’t just forget about property and equipment, especially for a business that can be capital intensive, like many tree care businesses.

Depreciation and amortization are excluded from EBITDA, because they are considered noncash expenses. These expenses result from cash expenditures that benefit multiple periods and must be separately analyzed.

Interest is excluded, because it is the result of financing and cash-management decisions that would not apply to a different owner.
Income-based taxes are excluded, because they are the result of the tax scenario and decisions of the business’s current owner and would not apply to a new owner.

Nonoperating or nonrecurring income is not included in EBITDA. These revenues are not a part of the core business and would not be applicable to a new owner of the business. A recent example of nonrecurring income that would be excluded is the forgiveness of a Paycheck Protection Program (PPP) loan.

Similarly, nonoperating or nonrecurring expenses can be excluded from your EBITDA calculation. An example might be legal expenses related to a lawsuit that is not a part of the core business.
Normalizing adjustments, sometimes called add-backs, can be added back to EBITDA. They account for differences between the way the current owner operates the business and the way it would likely be run by a new owner. Most businesses have add-backs. In some cases, they can be significant.

Table 1: Many factors will affect what multiple may be used by an acquiror to value a potential acquisition. Table courtesy of the author.

Adjustments

Here are some examples of common normalizing adjustments:
Owner’s compensation: The owner’s compensation in the income statement may be higher or lower than a market rate of compensation for the manager of a similar business. An adjustment should be made in the calculation to bring it to a market rate.
Owner’s benefits: If the owner receives benefits from the business that are not applicable to other employees and would not be applicable under new ownership, these items should be added back. Examples might include insurance benefits and travel expenses.
Family members employed in the business: Compensation and benefits for any family members employed in the business should be adjusted to fair market rates.
Rent: If the business owner owns the property from which the business operates, the EBITDA calculation should be adjusted to reflect the market rate of rent.

As noted above, the EBITDA formula leaves property and equipment out, but you can be sure that potential buyers don’t just forget about property and equipment, especially for a business that can be capital intensive, like many tree care businesses. We will address that later.

Not all EBITDA is created equal: Multiples

Once adjusted EBITDA has been calculated, it is multiplied by a factor to produce an estimated value. Multiples are usually expressed as a range. For example, a multiple range might be expressed as 3½x to 5½x adjusted EBITDA. The range applicable to a specific business will be determined by the market and will vary based on industry sectors and regional differences. The range of multiples and values can be fairly large. In the example of 3½x to 5½x, the high end of the range is nearly 60% higher than the low end.

Where a specific business will land in the range is subjective. A buyer will use its own investigation and judgment in determining where in the range a specific company should be valued.

Table 1 identifies many of the factors that will affect what multiple may be used by an acquiror to value a potential acquisition.

Cash flow

Another metric often used in business valuation is free-cash flow. Free-cash flow starts with EBITDA and adjusts it for changes in accounts receivable and payable and for capital expenditures.

Because capital expenditures can vary from year to year, buyers will look at them carefully. While an exceptional fleet may not add to the value of a business, deferred maintenance or replacements will likely hurt the value, because a prospective buyer will factor needed expenditures for equipment or repairs into their value calculation. One thing to remember is that replacing equipment can cause EBITDA to go up, as a result of lower repairs and maintenance costs.

Timing for EBITDA

When considering the value of their businesses, owners often ask during what periods EBITDA calculation is most important. They may have heard that business buyers focus on the last full year, the last three years’ average, the trailing 12 months or, in some cases, the current year’s projected EBITDA. Different buyers take different approaches, but I tell owners that the most important EBITDA calculation for the value of their business is next year’s EBITDA.

Buyers use EBITDA calculations, whichever periods they choose, in their evaluation of the expected future performance of the business. If the potential buyer identifies negative trends, they will be reflected in their valuation conclusions.

Conclusion

Building value in your business involves increasing your EBITDA and moving your multiple. Growing both can produce dramatic increases in business value.

Understanding your financial statements and EBITDA is critical to understanding the value of your business. Tracking EBITDA over time can help you measure the progress you are making in building value and make wise decisions in planning for the future of your business – whether that involves a sale of your business or not.

Ron Edmonds is a partner in Principium | White Oak Mergers & Acquisitions, a merger-and-acquisition advisory firm serving the lawn, landscape and related service sectors, and a five-year TCIA corporate member company based in Cordova, Tennessee. He has advised business owners in the lawn and landscape industry regarding mergers and acquisitions and business sales for 20 years. He has been published in a variety of industry trade publications and frequently speaks at industry events.