People often ask why we in the M&A industry almost blindly follow an earnings measure called EBITDA. Indeed, as an M&A professional who has been working in financial due diligence for 10-plus years, one of your co-authors, Adam Azulai, can probably count on one hand the occasions when a client was interested in a company’s net income or even the EBIT figure, for that matter.
Why is it that a non-GAAP earnings measure is so widely used in this industry, while it does not show up in companies’ annual reports?
Moreover, there is a lot of criticism regarding the use of EBITDA. Perhaps the most well-known ‘criticaster’ is Warren Buffett, who believes it may even be a proxy for fraud (I may be paraphrasing slightly). Warren Buffett certainly is not wrong. Navigating on EBITDA has its drawbacks and there are many ways to window-dress an EBITDA figure, the most important of which is to capitalise expenses on the balance sheet as much as possible.
EBITDA: a convenient solution
So why are we in M&A so fond of this EBITDA measure? The reason is that we are looking for a proxy for gross operating cash flow. We are looking for an income measure, without much judgement, that can demonstrate the cash-generating capability of a company. We are very much aware that companies require capital expenditures. We solve this with the EBITDA multiple figure.
M&A professionals generally apply an EBITDA times multiple approach to value a business. And capital-intensive businesses (generally) have lower multiples than businesses that are not capital-intensive. So we are solving for the absence of depreciation and amortisation in EBITDA by discounting a normative, industry-standard, level of fixed assets in the valuation multiple.
Going back to EBITDA; life would be easy if the story ended here, but the reality is that a company’s EBITDA figure is never ‘clean’. And because EBITDA is a non-GAAP earnings measure, businesses can make their own (sub)definition of EBITDA. Some examples are:
EBITDAR&D (excluding R&D);
EBITDAR (excluding rent or restructuring charges); and
EBITDAC (excluding capitalised development time).
In financial due diligence, we try to make sense of all this and present our view of a clean EBITDA figure. And this is where it becomes interesting for tax professionals. In financial due diligence, we dig deep into the uncharted caves of a company’s financial records to truly understand a company’s composition of EBITDA. And they are the shadowy corners where tax risks can occur.
Let us explore some examples.
Owner’s expenses
Business owners sometimes think that they are the ones who decide whether an expense is a justified business expense. The reality is, however, that for the tax authorities, there must be a causal relationship between the costs and benefit to the company. There is an infamous case in the Netherlands, ‘Cessna’, where a dentist purchased a plane to fly to his branch in Italy a few times a year. Clearly, this is not a valid business expense and a typical add-back to EBITDA.
Restructuring or M&A expenses
Throughout a business life cycle, companies can attract or change shareholders, split activities, rationalise legal entities and conduct many more activities that may appear business crucial, but are actually non-core. While business owners may think that these expenses are business expenses, the tax authorities may think that these are shareholder matters and non-deductible expenses.
In financial due diligence, these expenses are added back to EBITDA. It may therefore be worthwhile for tax professionals to have a chat with the finance professional to understand the nature of restructuring expenses and whether these are valid business expenses.
Stock-based compensation
Employee incentive plans such as stock options are particularly popular with start-ups and scale-ups. Providing stock or options to employees below fair value is, in the Netherlands, considered to be income from employment and therefore subject to payroll tax. We have seen phantom stock situations where the bonus payout had to be grossed up, becoming a non-tax-deductible expense and an extremely expensive measure to motivate management.
Two sides of the same golden coin
It would be easy to advise clients always to commission financial and tax due diligence with one firm, but the reality is that this is not necessary. The necessity is that finance and tax professionals should understand that they are analysing two sides of the same coin and therefore cannot work completely separately. There should be close lines of communication and tax professionals should be able to read and understand an adjusted EBITDA table.
Inversely, finance professionals should also know, or at least have a vague understanding of, the tax implications that EBITDA adjustments can have. At the very least, finance and tax professionals should run through their findings together to ensure that they report that shiny coin with two golden sides.