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Standardisation of EBITDA, or operating profit in the calculation of a company's goodwill

Bartosz MIŁASZEWSKI
Managing Partner at RSM Poland

An interesting matter is that it is often easier to buy or sell a big company employing thousands of workers with income counted in billions rather than a company that has several or several dozen employees and generates revenue of (just) several or several dozen million. And paradoxically, it is not about the price that needs to be paid for such an enterprise.

It would seem that the smaller a business, the less money is required, the less risk and, therefore, the simpler the transaction should be. Business practice, however, shows that the opposite is the case. Smaller businesses, meaning companies with revenues ranging from several to several dozens or tens of millions of zlotys a year, often are much more difficult to measure, and therefore to sell or buy.

I am selling a profitable company. Are you sure?

Firstly, access to information on small and medium-sized enterprises (SMEs) is quite different than in the case of large companies. Large companies have an organisational structure forced by their size: CFOs, controlling departments, budgets, financial reporting at a level sufficient to track the profitability of each product/service/trader. Internal financial reporting in smaller companies often does not exist at all or is the result of years of reflection of their owners corresponding to their needs and fantasies. So it is not standardised and sometimes is completely illegible for external stakeholders. Some other issues arise when it turns out that the entity to be acquired does not at all keep full accounts, and for many years has been striving not to exceed the threshold amount requiring to do so.

Secondly, a smaller company sometimes has many issues unrelated to the company. These include a contract of employment for a cousin who graduated from the Academy of Fine Arts and who prepares designs for his/her own pleasure, but the owner wants to pay him/her "because, after all, he/she is family." A car for someone’s wife and son who officially help in the company, but when asked about the details of their involvement in the business, it turns out that they visit the company once a month for informal rather than professional purposes.

The third problem with such transactions is that a small company is usually the owner, who is also the manager (often handling everything), there is no deputy in his/her absence, the company becomes motionless and unable to make decisions.

Fourthly, the emotional connection of the owners with their small business is much greater than in the case of corporations. In large companies, it is generally about money − the transaction pays off or not, and other factors recede into the background. It is different in the case of transactions concerning smaller companies. Psychology plays a very important role, and money often takes the second or even a more distant place.

Fifthly, the owner, and sometimes several co-owners, daily from early morning to later night are at the company and are not paid or receive a minimum amount of consideration. Or receive significantly higher amounts than the market practice...

Often when negotiating the terms of the transaction parties agree on a simplified valuation of the company: X times EBITDA (multiple of operating profit before financial costs, taxes and depreciation). At this point, the seller recognises: we reached a compromise, I know the price and it satisfies me, so now we will prepare a purchase agreement (SPA) and close the transaction. At this point the buyer performs due diligence which, to the amazement of the seller, shows that the value of the company is completely different than the one determined on the basis of the indicator. This is a classic communication error, which particularly often concerns smaller and medium-sized businesses. What to do to avoid it?

Valuation of goodwill

Not only the value of the multiplier (how many times EBITDA) needs to be established during the preliminary negotiations, but also at least:

  1. EBITDA base − e.g. the average of the last 2-3 years or other agreed period,
  2. Rules for standardisation of the result (standardisation of EBITDA)
  3. No cash rules − no debt (in particular, which debt is treated as lowering company goodwill)
  4. Method for determining working capital and its impact on the transaction price,
  5. Principles of distribution of the result for the last period in which the company is owned by the sellers.

Against the background of the foregoing, the key seems to be here establishing the rules for standardising the result. What is therefore, the standardisation of the EBITDA? How to carry out standardisation and establish a standardised result?

Like most areas in transactions − through negotiation. The parties agree between themselves the rules of standardisation of EBITDA specifying the items/events having an impact on the adjustment of the amounts reported in the financial statements to the value used to set the price of the transaction. The most common ones include:

  1. Proper attribution of income and expenses to the periods to which they relate,
  2. Elimination of one-off events (e.g. the result on disposal of property, paid contractual penalties),
  3. Elimination of expenses unrelated to business operations (hidden dividend),
  4. Write-downs on impairment of assets,
  5. Determining the depreciation rules,
  6. Transformation of operating leases into financial leases,
  7. Recognising as expenses the market value of remuneration for partners.

What is the purpose of standardisation of the result? First of all, determination of the actual company goodwill. Verification of trends in revenues, costs and profitability allows the buyer to build scenarios for the development of the company based on reliable information. If the buyer is a professional investor, they can compare the structure of revenues and expenses of the acquired company to the structure of other entities. Standardisation of the result allows you to determine the advantages and weaknesses of the acquired company. And this helps determine its real value and the transaction price.

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