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Key Idea: Calculate Your EBITDA

EBITDA is defined.

Key Question:

A: 

One thing you need to do is calculate your EBITDA.  This is a little technical but understanding this concept and why it matters is critical to your ultimate exit strategy. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Calculating your EBITDA is easy.
 
Take the bottom line of your income statement and add back all those items (interest, taxes, depreciation, and amortization). Simple, right? But understanding EBITDA and why it's important is what matters to you.

Q:
Why the focus on EBITDA?

A:
The EBITDA is probably the single most important factor in the buyer's evaluation of the acquisition target because it represents cash flow from operations. The purchase of your business is an investment from the buyer's point of view, and he or she will calculate the return on that investment. This return is generally calculated in the traditional percentage manner as well as in terms of the "payback period."

The payback period is calculated based on how many years it takes to recoup the cash and/or stock investment.

The more profitable the business, the higher the price the buyer will pay because the business will provide an economic return justifying a larger investment. EBITDA isn't the only thing the buyer will evaluate. If your business operates with a significant investment in equipment, the buyer will have the equipment appraised. What kind of capital investment will be required beyond the purchase price? If your equipment is aging and needs to be replaced, this could have a big impact on the purchase price.

Necessary capital improvements are considered separately by the buyer, that's why depreciation and amortization are not included in EBITDA.

Q:  Why add back taxes to calculate EBITDA? Isn't that a cost paid from cash flow? Won't the buyer have to pay the same taxes you did?

A:  You bet! There's an old Yiddish proverb, "You make your money; you pay your taxes." CPAs like to say that you can't let the tax tail wag the economic dog. Yes, the buyer will pay taxes on the profits of your business and yes those taxes will come out of the cash flow of the business. The reason taxes are not considered in the valuation of your business is because the buyer is considering your business as an alternative investment.

Wherever the buyer invests, assuming there is an economic return, there will be tax consequences. So whether the buyer is a publicly-held company, as in our stories of Tracy and Bob, a privately-held company, or individual(s), the future tax liability from the profits of your business are not part of the valuation model.

The same is true of interest. The buyer will take into consideration the cost of money, to be sure, but as with the capital improvements that may be required; the buyer's cost of money is independent from your cost of money. So just as the buyer will "add back" the depreciation and amortization you have recorded each year, he or she will similarly add back interest and take into account his or her own cost of financing the transaction.

If you pay yourself above industry standard, don't worry. Buyers realize this and will deduct from your overhead the salary and benefits you have been paying yourself. A new buyer will use what is called re-casted numbers to determine the value your company holds for them.

Think about it

Have you ever calculated your EBITDA? If not, why not? Do you think it is time to do it?

Clip from: Sell To A Public Company

La Jolla and Dallas: Every day the press reports, especially The Wall Street Journal and Forbes, about how big business acquires small businesses in order to grow.

If you are running a good business and have market share in your industry segment, you should consider preparing for that call or knock on the door, "Can I buy your business?"   In most every episode of this show we explore how and why the founder of a business gets started and how they get over the hurdles. This week we look at how they received a very large check for the fruits of their labor.

Today, we spend time with Tracy Myers and Gary Cantor, the founders of Advertising Arts College, and Bob Orenstein, founder of International Wine Accessories (IWA). Both have completed all eight steps within the business cycle, and they define what it means to "Exit At the Top." You met Bob a couple of years ago when we did his story about starting IWA from the extra bedroom of his townhouse.

Both stories are important.

Gary and Tracy's story is for all of us who are not even thinking about selling, then there comes a knock on the door.  Bob's story is for the rest of us who know that we have created a substantial asset. Bob, however, knew that his "time" was coming. Bob was strategic and spent several years getting ready for the day, and then it took over four years to consummate a deal.

To say the least, every one of us should have an exit strategy.

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International Wine Accessories, Inc. (IWA)

Robert Orenstein, founder

10246 Miller Road
Dallas, TX 75238
2143496097

Visit our web site: http://www.iwawine.com/

Office: 2143496097

Business Classification:
Home products

Year Founded: 1988

Calculate Your EBITDA

BOB: EBITA is a method of measuring a company's performance. It means earnings before interest, taxes — depreciation if its EBITDA — and amortization.

That was the accepted number that everybody used. The value of the company is based upon a multiple of your EBITA. So in this case, they were willing to pay $18 million for the company. However, there's a big difference between what they paid and the fixed assets. The difference there was divided into two categories. One was the value of the mailing list. And there was no value on the books for the mailing list because you accumulated over many years of running a business.

HATTIE: Exactly.
 
 

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