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There are many different ways to determine the value of a company during an M&A transaction. Most of the time, the purchasing price is based on some sort of multiple (such as Firm Value / EBITDA). But what is a company's real EBITDA? Let's assume that the buyer's investment bank decides to evaluate the target at 7 times its EBITDA. In order to accomplish a low transaction price, the buyer normally hires financial advisors from the transaction advisory department of a big4 company. Their role is to adjust the target's EBITDA and to calculate a normalized EBITDA.

Many privately held companies are run by their owner(s). In order to overstate the company's EBITDA and to inflate the valuation, the management may pay themselves a salary below market levels, thus understating personnel expenses and overstating EBITDA. The financial advisor would assume an more appropriate salary for the management by pushing up the salary to market levels until the target's EBITDA reflects the underlying business reality of the firm.

Another way to inflate a company's EBITDA would be to spin off (non-core) business units and to book the profits as other operating income. Since profits from spinning of business units do not belong to the company's core operating activities but inflate the company's EBITDA, financial advisors would also exclude such profits from the company's EBITDA.

Many companies are organized in a holding structure and carry out multiple intercompany transactions. Let's assume you have a group that is comprised of 2 companies. One company is responsible for managing the administrative part (the holding company) of the business and the other one is actually carrying out the operational parts of the business. In order to optimize their tax burden, both companies may want to report a neutral net income. (This really depends on the applicable tax laws)

But what happens when the operating company is not profitable but the holding company is? In order to "balance out" their net income with each other, the operating company can charge a management fee for providing all kind of recourses for the other company. In reality it is really difficult to proof if the reason for those management fees and the amounts charged are justified.

Management fees increase the net income (and EBITDA if it is booked as costs of material or administrative costs) of the operating company and decrease the results of the holding company. In case the buyer only wants to acquire the operating company, the financial advisor would subtract management fees received from the holding company from the company's EBITDA.

There are quite some ways to inflate a company's EBITDA in order to increase the purchasing price during an M&A transaction. Since there are far more ways to inflate EBITDA (such as increased revenue recognition, locked box vs. completion accounts and so on), I would appreciate additions /corrections from my fellow monkeys! How would you inflate EBITDA of your start up in order to achieve a high valuation and to buy yourself your own island after selling your company?

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Comments (18)

  • fringejacky's picture

    Very informative and solid!

  • randyross's picture

    Reclassifying nonrecurring or service-oriented revenue as ongoing revenue for a product-oriented business

  • iRX's picture

    Adjustments to think about in general, not necessarily to increase/decrease EBITDA.

    Non-recurring revenue/expenses.
    Above market rent expense. In many cases, the owners will lease office space to the company at above market rates. There are some legal/tax consequences that could arise to the buyer in certain of these situations, so be careful.
    Unreasonably high/low management salaries/bonuses.

    From the seller side specifically, many bankers will estimate synergies (assuming they exist - usually always in the case a strategic buyer) and try to make the buyer pay for them.

    Always do your homework. I saw one company actually adding back interest expense to EBITDA under a general admin expenses line item. Most of the time diligence is performed by big 4, but you should still be aware.

    Most buyers will indemnify/allocate a portion of the PP to escrow for a few years in the case that anything is misrepresented or tax/legal issues come up that would result in buyer liability.

  • ladubs111's picture

    there a lot of ways. ASC605 (i believe) is accounting estimate for long term projects like large construction work where management has to estimate completion of project and recognize revenue and expenses to the milestones. Good luck estimating completion % of a project.

  • BatMasterson's picture

    Good post ! +1 SB points for you.

    "Add-backs" might be any expenses personal to the current ownership.

    "I like money (as do most females) but love is...great :)"-student
    "Perhaps you've failed to take into account my hidden assets"-007
    Looming Hurricaine

  • MistaBooks's picture

    I am curious why (for PE acquisitions) the PE shops don't just do this work themselves? Why do they feel it is necessary to hire a Big 4 firm to come in?

    Do they do the work themselves and just bring in the advisory arm of Big 4 to kind of 'double check'?

    I would think the associates at the PE shops would be perfectly capable of doing this type of diligence..

    Thoughts?

  • corporateape's picture

    Good questions! They don't do this work on their own because it is really time consuming and requires deep financial accounting knowledge. You want to hire someone who is an expert in this! Although some private equity guys may have a relevant background in financial due diligence they are busy with other stuff such as sourcing new investment opportunities, implementing business plans and financial modeling. However, I believe that some PE shops who have the necessary internal recourses do financial due diligence on their own in order to save costs. Not sure about this though. Does anyone have first hand experience?

  • In reply to MistaBooks
    oreos's picture

    MistaBooks:
    I am curious why (for PE acquisitions) the PE shops don't just do this work themselves? Why do they feel it is necessary to hire a Big 4 firm to come in?

    Do they do the work themselves and just bring in the advisory arm of Big 4 to kind of 'double check'?

    I would think the associates at the PE shops would be perfectly capable of doing this type of diligence..

    Thoughts?


    have you ever read vendor DD? it's not pretty and a lot of effort goes into them, this isn't stuff you can glean from the statments. to reductio ad absurdm your thought process, why do we need lawyers? bankers? or any service industry...why don't we all just do it ourselves?

    "After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

  • In reply to oreos
    MistaBooks's picture

    Oreos:
    MistaBooks:
    I am curious why (for PE acquisitions) the PE shops don't just do this work themselves? Why do they feel it is necessary to hire a Big 4 firm to come in?

    Do they do the work themselves and just bring in the advisory arm of Big 4 to kind of 'double check'?

    I would think the associates at the PE shops would be perfectly capable of doing this type of diligence..

    Thoughts?


    have you ever read vendor DD? it's not pretty and a lot of effort goes into them, this isn't stuff you can glean from the statments. to reductio ad absurdm your thought process, why do we need lawyers? bankers? or any service industry...why don't we all just do it ourselves?

    I was more curious b/c on a lot of profiles of associates in PE shops it lists 'due diligence' as one of their responsibilities

  • In reply to MistaBooks
    oreos's picture

    MistaBooks:
    Oreos:
    MistaBooks:
    I am curious why (for PE acquisitions) the PE shops don't just do this work themselves? Why do they feel it is necessary to hire a Big 4 firm to come in?

    Do they do the work themselves and just bring in the advisory arm of Big 4 to kind of 'double check'?

    I would think the associates at the PE shops would be perfectly capable of doing this type of diligence..

    Thoughts?


    have you ever read vendor DD? it's not pretty and a lot of effort goes into them, this isn't stuff you can glean from the statments. to reductio ad absurdm your thought process, why do we need lawyers? bankers? or any service industry...why don't we all just do it ourselves?

    I was more curious b/c on a lot of profiles of associates in PE shops it lists 'due diligence' as one of their responsibilities


    a banker's DD activities consist of: going to the factory, looking at it and going "yes, that is a factory" then walking around, nodding his/her head at what they're being told and stringing that out for a while; and reading DD reports (legal, tax, insurance bla bla bla)

    "After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

  • In reply to oreos
    MistaBooks's picture

    Oreos:
    MistaBooks:
    Oreos:
    MistaBooks:
    I am curious why (for PE acquisitions) the PE shops don't just do this work themselves? Why do they feel it is necessary to hire a Big 4 firm to come in?

    Do they do the work themselves and just bring in the advisory arm of Big 4 to kind of 'double check'?

    I would think the associates at the PE shops would be perfectly capable of doing this type of diligence..

    Thoughts?


    have you ever read vendor DD? it's not pretty and a lot of effort goes into them, this isn't stuff you can glean from the statments. to reductio ad absurdm your thought process, why do we need lawyers? bankers? or any service industry...why don't we all just do it ourselves?

    I was more curious b/c on a lot of profiles of associates in PE shops it lists 'due diligence' as one of their responsibilities


    a banker's DD activities consist of: going to the factory, looking at it and going "yes, that is a factory" then walking around, nodding his/her head at what they're being told and stringing that out for a while; and reading DD reports (legal, tax, insurance bla bla bla)

    That sounds awsome

  • In reply to MistaBooks
    corporateape's picture

    MistaBooks:
    Oreos:
    MistaBooks:
    Oreos:
    MistaBooks:
    I am curious why (for PE acquisitions) the PE shops don't just do this work themselves? Why do they feel it is necessary to hire a Big 4 firm to come in?

    Do they do the work themselves and just bring in the advisory arm of Big 4 to kind of 'double check'?

    I would think the associates at the PE shops would be perfectly capable of doing this type of diligence..

    Thoughts?


    have you ever read vendor DD? it's not pretty and a lot of effort goes into them, this isn't stuff you can glean from the statments. to reductio ad absurdm your thought process, why do we need lawyers? bankers? or any service industry...why don't we all just do it ourselves?

    I was more curious b/c on a lot of profiles of associates in PE shops it lists 'due diligence' as one of their responsibilities


    a banker's DD activities consist of: going to the factory, looking at it and going "yes, that is a factory" then walking around, nodding his/her head at what they're being told and stringing that out for a while; and reading DD reports (legal, tax, insurance bla bla bla)

    That sounds awsome

    This conversation made me smile! :)

  • monkeyc's picture

    reading the reports is a specialized skill in and of itself.

  • vitaminc's picture

    How to inflate EBITDA? Don't and not worth it. Try to do acqhire model at $1MM per engineer/employee; traffic/subscribers/users, or if you are a SaaS company, 10x forward sales with a golden parachute and a seat at the executive ranks.

  • motionfx's picture

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  • In reply to motionfx
    oreos's picture

    "After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

  • In reply to motionfx
    oreos's picture

    "After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

  • alexpasch's picture

    Consultant to a Fortune 50 Company