Dr. Bill Wagner
What’s the deal with EBITDA?
Anyone who has explored the process of buying or selling a veterinary practice in the last couple of decades has likely encountered an acronym that isn’t taught in most veterinary medical schools:
“Multiple of EBITDA” has become the prevailing core metric by which veterinary practices are valued, largely supplanting other measures such as “Multiple of Revenue” and “Multiple of Seller’s Discretionary Income (SDE).”
This week I’ll be explaining what EBITDA is, how it is used, and the pros and cons of its utilization in business valuation.
What is EBITDA?
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is intended to be a proxy for profitability that translates well during transfers of business ownership. It excludes expenses related to seller’s debt (which most commonly is not retained through a change in ownership), taxes and non-cash accounting deductions (e.g. depreciation or amortization).
EBITDA can serve as a general measure of the cash flow available for a buyer to provide return on investment and service new debts.
How is EBITDA calculated?
To arrive at an EBITDA figure, first we need to calculate net income. Net income is a relatively straightforward calculation:
Net Income = Total Revenue – Total Expenses
To convert net income into EBITDA, there are several adjustments that need to be made. Most notably, four expense categories are added back to net income: interest, taxes, depreciation, and amortization.
EBITDA = Net income + Interest + Taxes + Depreciation + Amortization
Most of those items should be familiar and readily available from your typical tax return or profit & loss statement. Most buyers will then adjust that reported EBITDA figure in order to better reflect expected future performance:
Adjusted EBITDA = EBITDA + Other Add Backs + Fair Market Adjustments
“Other Add Backs” are expenses that were included in the calculation of Net Income that a buyer can reasonably expect will not continue in the business after the change in ownership. This includes personal expenses of the seller that are being listed as business expenses, as well as truly “one time” expenses that fall outside of the realm of normal business expenses.
“Fair market adjustments” are adjustments to the personal compensation of the owner and to other key expense categories like expensed rent if the seller was not expensing an amount equal to fair market value for those categories. Often sellers will “overpay” or “underpay” themselves for their own clinical work or in the rent that they expense the business if they own their own property for the purpose of tax efficiency. However, a buyer needs to budget for paying fair market value for normal business expenses like clinical work and rent. EBITDA must be adjusted accordingly to match with that expected expense. Notably, those adjustments could be both negative or positive.
How is EBITDA used to value a business?
To arrive at a valuation, EBITDA is multiplied by a “valuation multiple”.
For example, a practice with $200,000 of EBITDA and an assessed valuation multiple of 5 would be valued at $1,000,000 ($200,000 x 5).
The valuation multiple is determined by weighing a variety of factors.
For veterinary practices, these factors include:
Multiples paid for similar practices that have recently been sold (varies by geography)
The number of veterinarians employed by the practice
Whether the practice is urban/suburban/rural
Assessed growth potential
Whether the practice is individually owned or part of a larger group
Degree of local competition
The practice’s local reputation and degree of client goodwill
Quality of equipment and facilities, including assessment of imminent expenses
Any unique aspects of the practice that add value to a buyer
Any risks (including keyperson risk at smaller practices) associated with the business that might negatively impact a buyer in the future
What are the pitfalls of using EBITDA to measure value?
EBITDA doesn’t tell the entire story. Understandably, trying to boil the financial performance of an entire business down to a single figure means losing all the nuance. Sophisticated business buyers and sellers need to understand the “why” behind an EBITDA figure to understand and utilize it. Calculating EBITDA isn’t a substitute for thorough due diligence. A buyer needs to build context around why past performance will be reflective of future performance. If it isn’t, their offer needs to reflect that.
$0 EBITDA businesses are not actually zero value businesses, even though an EBITDA-based valuation will tell you that they are. EBITDA-based valuations operate under the assumption that intangible assets like goodwill and tangible assets like equipment contribute towards generating EBITDA. For that reason, an EBITDA-based valuation does not account for those assets separately and treats them as already being inherently included in the valuation. However, that is not the case as we approach the fringe scenario where EBITDA decreases to zero or a negative amount. In reality, those businesses still have inherent value in their intangible and tangible assets even though they are not currently translating into creation of profit. For this reason, another valuation system such as Multiple of Revenue, Multiple of Seller’s Discretionary Income, or an Asset-based valuation would be better suited for trying to value an unprofitable business.
Two identical-EBITDA businesses can be very different in current and future value. Growth potential, opportunity for margin expansion, quality of care, skill and motivation of the employees, quality of the facilities and equipment, location/geography, and a variety of other factors can set two practices that have the same EBITDA figure on paper far apart from each other in true value. Therefore, a sophisticated buyer must put careful thought and analysis into picking an appropriate valuation multiple.
Depreciation and amortization and the expenses that they represent matter. A business with significant looming capital investments in equipment and facilities should be valued less than one whose owner spent a lot of money increasing the business’ physical asset value; however, EBITDA does not account for recent or looming capital expenditures. This is another situation where sophisticated buyers will look beyond EBITDA in doing their due diligence. This can be accounted for by adjusting valuation multiple or applying add backs to reward a seller for setting new ownership for success, and reducing valuation for a business that will require significant capital investment in the first few years of new ownership.
As we can see, EBITDA is a very useful metric for valuing businesses such as veterinary practices – with the important caveat that there is much more due diligence that must be done to understand the “why” behind a business’ EBITDA and construct an accurate valuation with an appropriate valuation multiple.
Tune in for our next blog where we will discuss what you can do as a practice owner to improve your practice’s EBITDA to boost your equity value. If you’re a practice owner or an entrepreneurial veterinarian interested in learning more about partnership opportunities with AVP, please contact me at email@example.com to find out more.
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