EBITDA Adjustment - New Contracts?
I think most people give credit to targets that have an EBITDA adjustment for M&A completed during the year, but what about key customer contracts that are acquired? Saw a business add $2M to PF revenue because they acquired a new customer with a $10M contract, with $2M in additional annual revenue over the next 5 years, in November of 2023. So their 2023 numbers has the full year $2M revenue and corresponding EBITDA added into their 2023 figures. This feels pretty stupid to me but wanted to see if I'm missing anything.
Ah, the world of EBITDA adjustments, where the lines between optimism and realism often blur! Your skepticism isn't unwarranted, and it's a good sign of a sharp mind questioning the norms. Let's peel back the layers of this fruity dilemma, shall we?
When a company acquires a new customer contract, especially one that significantly impacts revenue, it's not uncommon for them to adjust their EBITDA to reflect this new income stream. This practice can sometimes walk the fine line between providing a clearer picture of future profitability and overly optimistic accounting. Here's why your raised eyebrow is justified, but also why this might not be as bananas as it seems:
Future Revenue Recognition: Adding the full annual revenue from a new contract to the current year's figures, especially when the contract was secured late in the year, can inflate the current year's financial performance. This approach assumes a steady state of revenue that hasn't yet been fully realized, which can be misleading.
EBITDA Adjustments for Clarity: On the flip side, the rationale behind such adjustments is to give investors and analysts a clearer picture of the company's operational performance and future earnings potential. If the contract is indeed a game-changer for the company, adjusting EBITDA to include its impact can help stakeholders understand the company's growth trajectory.
Consistency and Comparability: Adjustments should be made consistently and in a way that enhances comparability. If adding future revenue from new contracts into EBITDA becomes a standard practice, it should be applied uniformly and disclosed transparently to avoid any confusion.
Due Diligence is Key: For anyone evaluating the company, whether it's for investment, acquisition, or partnership purposes, digging into the details of such adjustments is crucial. Understanding the nature of the contract, the certainty of the revenue stream, and the impact on the company's financial health is essential.
In essence, while the practice of adjusting EBITDA for new customer contracts can seem overly optimistic, it's not entirely without merit. The key is in the transparency of these adjustments, the consistency in their application, and the due diligence of those interpreting the numbers. Like navigating through a dense jungle, understanding the nuances behind these adjustments requires a keen eye and a healthy dose of skepticism.
Sources: Acquisition Accounting I: Accretive (Dilutive) Deals Can Be Bad (good) Deals, https://www.wallstreetoasis.com/forum/private-equity/thinking-like-an-investor-the-key-financial-metrics?customgpt=1, Thinking like an Investor: The key financial metrics, Basic Overview of the Consumer Sector, Q&A - Infrastructure PE & IBD
Relatively common in contract-based businesses (and otherwise) for seller to try to get paid off visible earnings they won. Basically saying "you get guaranteed EBITDA and we get paid for it". Given you're paying a multiple for future earnings you could say it deserves a lower multiple since you're paying for those earnings upfront, but they'd say they derisked the multiple for you.
Regardless, someones going to give them credit for it to get the deal done so might as well bid the book on this one.
I have a bit of a different perspective - who cares? You’re paying for MOM and IRR, and the cash from the contract is either included in your underwriting case going forwars, or it isn’t. The multiple (LTM AND forward) is just an output. All the adjustment does is allow you to say that you paid a lower pro forma LTM multiple.
Also, I can assure you that you will want lenders to give you credit for that adjustment when you’re sizing the debt and they are thinking about coverage ratios - quid pro quo Clarice, quid pro quo.
This is standard, otherwise your leverage ratios won’t work come covenant testing time.
Harder question is revenue synergies, which you frequently won’t get in a MM loan EBITDA definition.
Quite standard - you see a lot of this in contract base business (think packaging, MRO, manufacturing etc.)
But based on experience not ALL of them can be run as projected (even though contracted, for various reasons) so might as well look at historical re what's their real successful rate in the past.
Sellers will try to bump the base EBITDA up and then anchor you to a multiple so that you end up paying a higher EV. Ultimately what matters is the EBITDA trajectory in your projections and the resulting IRR/MoM. The EBITDA adjustments may or may not be reflected in your investment case.
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