Understanding EBITDA Adjustments Through a Buyer’s Lens

In almost every transaction, you’ll hear the purchase price stated as a multiple of adjusted EBITDA.

John MosserMost owners think of an EBITDA adjustment as an accounting exercise, but Adjusted EBITDA is not an accounting standard. It is a negotiated number, built on judgment, and the person presenting it has to be able to defend it. At a six times multiple, a $200,000 adjustment is $1.2 million of purchase price, and that is before considering what it does to the debt a lender will support. 

Often, a private business's adjusted EBITDA will be very different from the adjusted EBITDA an acquirer will take over. Privately held finishing businesses may be run to serve customers, support a family, and manage taxes, and the financial statements reflect that. Adjustments help bridge the gap between how a business has been run and how someone else would run it.

Credibility Is Worth More Than the Total 

Before getting into the categories, it’s important to address credibility as a seller when contemplating a potential sale.

When a buyer opens a package and sees a long list of aggressive adjustments, several of which are obviously not supportable, the immediate reaction is likely to discount the financial information as a whole. It rarely takes much investigation to recognize that something doesn't belong, and once a buyer concludes the numbers have been stretched, they view every other figure in the package through a skeptical lens. In some cases, they never engage at all because the adjusted number implies a valuation expectation far enough from where they would land that a successful closing looks unlikely.

Presenting a figure you have no intention of honoring after closing only creates a problem you will have to unwind later, and the lease always gets negotiated.

The opposite is just as true, and this is one of the few moments early in a process where real trust gets established. Buyers are not surprised that a family-owned business has personal expenses running through it. What they are looking for is whether a seller can explain each item, support it, and identify the adjustments that work against them as readily as the ones that work in their favor. A schedule that meets that standard shows honesty, builds trust, and establishes credibility; the benefit shows up later when diligence questions are answered quickly and without friction.

Owner Compensation and Personal Expenses

This is the largest category in most transactions and generally the least controversial. It includes compensation paid to the owner above or below market, family members on payroll, personal vehicles, travel, club memberships, life insurance, and personal professional fees.

Family members who perform real work are not an adjustment. If someone will have to be hired to do what they do, the cost stays in the business.

The more nuanced question is the owner’s compensation, because adding back the full amount isn't automatically appropriate. In many finishing companies, the owner is active in the business and often integral to it, which means the buyer will need that work done after closing. The right question is not what the owner was paid, but rather what an independent third party would have to spend to get the same job done. Sometimes that favors the seller, when an owner has been drawing well above a market salary for the role. We have also seen owners preparing to retire who were effectively performing three positions. Once you price out what it takes to replace all of them, the adjustment is negative, not positive. 

Related Party Items and Real Estate

Most owners who own the real estate will hold the building in a separate entity, and the rent between the two is often set for tax reasons rather than market reasons. Buyers will normalize this. Rent expense that is above market creates an add-back, and rent below market creates a reduction to earnings, which is the one that tends to surprise sellers.

If you own the building and intend to keep it, the rent in your adjusted numbers should be the rent you actually plan to charge once you are the buyer’s landlord. Presenting a figure you have no intention of honoring after closing only creates a problem you will have to unwind later, and the lease always gets negotiated.

The more common issue in this industry is the line between expense and capitalization. Tank rebuilds, rectifier replacements, line refurbishments, and major equipment overhauls could be expensed in one year and capitalized in another, often depending on what the tax picture called for at the time. 

The same approach applies to purchases from or sales to an affiliated company, management fees paid to a holding entity, and shared employees or facilities across two businesses. Each should be restated to what it would cost at arm’s length. Shared services are the most difficult, because they require an allocation (sometimes highly subjective) both sides can defend, and the cleanest answer is usually to separate them before a process begins.

Non-Recurring Items

This category covers costs (or income) that genuinely happened but are not expected to repeat. Common examples include a legal settlement, a facility move or plant reconfiguration, start-up inefficiency on a new line, a system implementation, an unusual bad debt from a single customer failure, or professional fees from pursuing an M&A transaction.

The test buyers apply is whether the item is truly isolated. One employment claim is an event, but a pattern of them is an operating cost. One severance payment is non-recurring, while severance in each of the last four years suggests turnover.

Two industry-specific items deserve attention. Environmental spending presented as one-time receives more scrutiny to determine if more spending will be required. Separately, we often see companies earn income from government grants or one-off development projects. That income was real in the year it was received, but without a consistent history of that kind of work, a buyer will remove it from their analysis. In that case, the adjustment reduces earnings rather than increasing them.

Accounting Adjustments

Buyers will also evaluate the accounting policies and procedures of the company. If a company reports on a cash or modified cash basis, expect the numbers to be restated to accrual, since timing can move earnings between periods in ways that have nothing to do with performance.

The more common issue in this industry is the line between expense and capitalization. Tank rebuilds, rectifier replacements, line refurbishments, and major equipment overhauls could be expensed in one year and capitalized in another, often depending on what the tax picture called for at the time. Buyers will normalize this to a consistent policy they would expect going forward. Where a significant expenditure extended the life of an asset and was run through the income statement, that is a legitimate adjustment and worth identifying, as it typically increases EBITDA.

Proforma and Run-Rate Adjustments

These are forward-looking and the most heavily negotiated category. They include annualizing a new line installed partway through the year, a price increase already implemented, a new program that has launched, or cost savings already executed.

Buyers need to see credible evidence to support adjustments like these. A price increase already accepted by customers, a program with a purchase order and a release schedule, or a headcount reduction visible in the last several months of payroll are all credited. Capacity alone is not rationale for a credible adjustment, and a new line running at thirty percent utilization is an asset, not sustainable earnings.

This is also the category where creative deal structure comes into play. An owner has invested in a new line, the money is already spent, and they are confident the volume is coming. That confidence is usually well founded, since nobody installs a line they do not believe in. What is missing is a signed contract on commercially reasonable terms that secures the return on it. With an agreement behind it, the pro forma adjustment is relatively easy to get credited. Without one, the buyer is being asked to pay today for volume that has not materialized. They are working through whether the earnings are the product of work the seller has already done, or whether the buyer will be the one investing to fill the excess capacity in the asset they just purchased.

Rather than an argument that leads to no deal, this is often bridged with structure. A buyer may agree to pay for the capital investment itself, on the view that the decision was the right one, and then tie an earnout to the earnings growth the line is expected to produce over a reasonable period. 

Be Aware of Potential Negative Adjustments

Sellers tend to prepare for the add-backs and overlook the negative adjustments. What makes these difficult is that they are often never discussed. A buyer may identify them in their due diligence, factor them into their analysis, and present a headline price. You may see the number without the reasoning behind it, so an adjustment you never anticipated shows up as a lower valuation with no explanation.

• Below market wages: A production workforce paid under local market and held together by loyalty to a transitioning owner. The new owner, without that same loyalty, may see a risk of losing people. The most obvious solution is to raise wages to market level, which is a permanent future cost.
• Unstaffed roles: No controller, no quality manager, or no plant manager, because the owner covers it all. An acquirer is unlikely to fill all those roles with one person at the same wage so that go-forward costs may be higher than the owner’s prior salary.
• Deferred maintenance: Capital spending pushed off for several years shows up either as a price reduction or as a higher normalized capex or maintenance cost assumption, and sometimes both.
• One-time earnings events: Income that arrived in a single year without drawing on the core business, such as a one-off project opportunity, an insurance recovery, or a gain on the sale of equipment. If a buyer does not expect it to recur, it is removed from earnings.
• Known forward compliance costs: Permit changes, added monitoring, or treatment upgrades that are coming regardless of who owns the business.

A schedule that includes the items working against you is immediately more credible than one that does not, and it signals that the rest of the numbers have been prepared honestly. A first impression of a trustworthy seller sets the right tone for a successful transaction.

What This Looks Like in Practice

A simplified example, using illustrative figures:

Every line in a schedule like this should be supportable with documentation a buyer can review. 

Do You Need a Quality of Earnings?

A quality of earnings analysis is an independent review, usually performed by an accounting firm, that tests whether reported earnings reflect the business's ongoing economics. It examines the adjustments, the accounting policies behind them, revenue recognition, working capital, and the consistency of the numbers across periods.

You’ll typically see other M&A content that says a quality of earnings report is always needed if you want to sell your business. However, we view this differently: a sell-side quality of earnings report is not always necessary. Depending on how clean the books are and the likely size of the transaction, the cost may not be justified. What is always necessary is going into a process confident you know your numbers and that they will hold up in due diligence, because the buyer will usually (not always, depending on the buyer) perform their own quality of earnings regardless. The purpose of preparation isn't to produce a report because someone said you need to; it is to ensure there are no surprises in due diligence.

Infrastructure Behind the Numbers

Underneath all of this is a more basic question of whether the business has the systems and the people to produce reliable financial information in the first place. Shops that close the month on schedule, track costs at the job level (accurately), and understand where the business actually makes money can support their adjustments quickly. It also guards against an uncomfortable surprise. We have seen owners who were confident that a particular customer was among their most profitable, only to find in diligence that related processes serving that same account had never been allocated to it. The true margin was far thinner than anyone thought.

That capability is worth building whether or not a transaction is ever contemplated. Knowing what it costs to run a particular part, which customers are profitable, and which work is being priced below cost improves budgeting and day-to-day decisions long before it improves a purchase price. 

Know Your Numbers

Adjusted EBITDA should be thought of as an exercise in presenting the right earnings number, a number you can defend, and supported by documentation.

If you are thinking about a transaction in the next few years, the useful work is understanding your own numbers well enough to know what a buyer will see and how those numbers should be positioned. That is a conversation worth having early to ensure there isn’t a significant valuation misalignment, and it is one we are always glad to have and help owners evaluate.

John Mosser is Managing Director at Triscend Partners. For questions about this topic or to discuss your specific situation, contact John Mosser at john@triscendpartners.com.