What Should You Look For When Considering a Business to Purchase? Unfortunately, too many prospective buyers want to know the asking price first and then how much money can they make. These are the wrong questions to ask initially. You need to know how much cash the seller requires as a down payment. There is no point in looking at a business no matter how good the numbers are if the seller wants three times as much cash as you are willing to invest.
Remember the actual amount of money a business earns is usually much more than just the bottom line. A smart approach is to get more information on the business, and even make a visit, before ruling it out or getting too involved in the numbers. It's all part of the learning process.
Forget About EBITDA
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) gained prominence within the investment community during the 1980s because it represented a number that could be used to determine the gross dollars that could be made available to service acquisition debt. At that time, EBITDA was more relevant because the deal criteria of the typical sponsor excluded companies that required significant investment for capital expenditures, research and development, or inventory. Less re-investment in the company meant that a larger portion of the EBITDA was available to service acquisition debt.
EBITDA remains popular as an earnings base for determining purchase price multiples and investment returns, although its popularity far exceeds its usefulness. In fact, when it comes to acquisition pricing and analysis, EBITDA has a number of serious limitations.
Taken together, the risk of using EBITDA is that you may very well pay too much for the following reasons:
EBITDA is the most "gross" earnings base and it gives the appearance that more cash is available than there actually is.
It's the largest profit metric and makes multiples seem smaller.
It doesn't reflect the actual economic depredation on the company's assets.
It makes a poor price multiple because the percentage of depreciation and amortization can vary from company-to-company.
EBITDA is NOT cash flow.
It does not reflect any increased demands on working capital.
It does not reflect required capital expenditures.
It does not reflect the costs of debt.
It does not include changes in long-term debt.
It does not include taxes.
It does not represent the actual dollars that are available to service debt.
It does not represent the dollars available for distribution to equity investors.
Again, the most fundamental danger of using EBITDA is that you will overpay. The earnings base will seem higher and the purchase multiples will appear smaller. Worst of all, you will not have a reliable estimate of the actual dollars available to the investors. So, do yourself a favor and follow the advice of Donnie Brasco's would-be investment banker: Forget about EBITDA. |
