Normalized EBITDA

✨ In summary

Normalized EBITDA is a key component to estimating the value of a client's business. It represents a business’s ability to generate earnings in the future based on historic earnings and adjustments to remove unusual, non-recurring, or discretionary expenses to better reflect true earnings.

Adjusting earnings for business valuation is a nuanced and complex task. Work with your client and their accountant directly to identify which expenses make sense to "add-back" to normalize EBITDA when estimating business valuation.

How to normalize earnings with "add-backs"

Most businesses have some amount of expenses that are not directly critical to operations.

Since "the market" (hypothetical prospective buyers) will remove any non-critical expenses to realize full earning potential, historic earnings need to be adjusted for there discretionary or unusual expenses to better estimate what the value of the business may be. This process of "adding-back" expenses normalizes earnings to better reflect the business's true valuation.

Estimating normalized EBITDA

Normalized EBITDA = Weighted Average of Historic EBITDA + Adjustments to Normalize EBITDA

Without normalizing earnings by including add-backs, your client's business value may be underestimated. Likewise, if add-backs are overstated this may lead to overestimates of valuation.

Example "add-back" expenses

Examples of expenses that may be added back to normalize EBITDA include:

Profit sharing or incentive compensation plans. This may include expenses around pension plans, 401K profit sharing, deferred compensation plans, and profit sharing incentives.
Excess owners compensation expense above what a replacement salary would cost. Owners work hard to build income generating businesses and have every right to pay themselves well as a result! In the event they transition ownership, the business will have to pay someone to replace the owner's functional role. The difference between what the business would pay a replacement of the owner and what the owner is earning today may be considered an add-back expense in some cases.
Strategic and/or one time expenses not directly tied to current operations. This may include salaries, technology investments, or professional fees associated with future growth initiatives or one time projects.
Discretionary expenses. Any expenses that are considered at the owner's discretion and not critical to maintaining current operations. This may include charitable contributions, excess travel costs, country club fees, and culture-building type of expenses.

Request an estimate of "add-backs" from clients

It's best to work with your client or their accountant to understand if they have any of these types of expenses and consider if an appropriate adjustment is needed to normalize earnings.

Identifying which expenses used to normalize EBITDA is a nuanced and complex task and is a difficult exercise to conduct by looking at the typical business tax return alone.

Asking clients about what expenses are not critical to operations is the best way to capture this data.

Frequently asked questions

How do adjustments to normalize EBITDA play a role during negotiations with a prospective buyer?

Since adjustments to normalize EBITDA are nuanced and can have meaningful impacts to a business valuation, prospective buyers scrutinize add-backs carefully during negotiations. All expenses included as add-backs to normalize EBITDA should be well documented and defensible.

What are the implications of relatively large adjustments to normalize EBITDA?

Relatively large amounts of add backs should be reviewed carefully with clients and their accountant

Since add-back expenses are negotiable during a sale, it is best practice remove such expenses from flowing through the business in the 1 to 3 years leading up to a sale. This is the best way to reflect true earnings and leaves less room for negotiation.
This should be balanced with a tax planning conversation, since many times the discretionary expenses that can be categorized as a valid "add-back" reduce the taxable income of the business and by extension the owner in many cases.

How can financial advisors gather the data needed to estimate adjustments to normalize EBITDA?

It's best to work with your client or their accountant to understand if they have any expenses that may be considered unusual, discretionary, or non-recurring and consider if an appropriate adjustment is needed to normalize earnings.

✉️ Use this email template to start the conversation

Subject: Non-operational / Discretionary expenses

Hello,

We're working on a valuation estimate for you and want to make sure the current value of the business is not underestimated.

Can you help us understand how much of your annual business expenses would reasonably go away if the business hypothetically changed hands?

When estimating business value, expenses not directly critical to current operations are typically added back to earnings to better reflect the business's ability to generate earnings.

Including a list of expenses that are commonly added back to earnings during valuation estimates for you to consider:

Profit sharing or incentive compensation plans.

Compensation you pay yourself that is above what you might pay your hypothetical replacement after you transition.

Salaries, technology investments, or professional fees not directly critical to current operations.

Discretionary expenses like charitable contributions, excess travel costs, country club fees, and culture-building or leadership retreats.

Thank you!

How is normalized EBITDA used to estimate business valuation?

Normalized EBITDA is the main component of two key methods used to estimate business valuation:

(Income Approach) Capitalization of Earnings: Under this method, normalized EBITDA is divided by a capitalization rate to estimate business value
(Market Approach) Industry EBITDA Multiples: Under this method, an earnings multiple taken from industry benchmarks is applied normalized EBITDA to estimate business value