Most business owners want to do whatever they can to reduce their tax liability. To achieve that, they do whatever they can to reduce their company’s cash profits including deducting several additional expenses. If you use this strategy, it is a perfectly legal and acceptable way to reduce the amount of taxes you have to pay. However, this same method can also hurt you when it comes time to sell your business.

When selling a business, your goal should be to show buyers why it is worth the asking price. To do this effectively, you must understand why buyers, as well as lenders, care about your EBITDA. EBITDA is a line on your financial statement that represents your company’s earnings before interest, taxes, depreciation, and amortization. It is superior measure of company performance because it is able to show earnings before the influence of expenses that are outside of management’s control. EBITDA is important to buyers because it is an accurate measure a business’s financial health and overall value. For lenders, EBITDA helps to calculate the amount of money a buyer can borrow when purchasing a business.

Using EBITDA for business valuations

Cash profits are not always a clear indicator of how a business is performing. Take the following example of two different businesses in the same industry. One business could be growing and actively investing in its future. In doing so, they open new offices, add new equipment, and invest in new processes. While these investments help the company to grow, they also bring the cash profit down significantly. At the same time, they would not affect EBITDA, because they are below that point on the financial statement.

Another, similar business, may not be making these same investments. As a result, their cash profit would be higher. By that same token, they are not investing in their future growth, which is not as attractive to most buyers. A buyer who decides to invest in the business may have significant deferred expenses down the road due to the lack of investment in maintaining and building the company. With that said, if buyers were focused solely on cash flow, this business would be seen as more valuable than the one that is actively investing in its growth.

EBITDA helps to normalize value indicators to give buyers a financially accurate picture of the business. While it is an important financial indicator for buyers, they will also consider other financial metrics in their investment decision. Their perception of the business will depend on other non-financial aspects of the business as well, such as leadership, growth, culture and industry health, among others. Lenders will take a much more objective look at the business and put a heavier emphasis on EBITDA.

How lenders use EBITDA for SBA financing

A business that is eligible for SBA lending is much more likely to sell. It can be marketed to buyers that require financing, which increases the pool of potential investors. If you work with a business broker, they typically have lender connections that can help pre-qualify your business for an SBA loan before listing it. Underwriting Cash Flow (UCW) determines how much SBA money buyer can borrow when purchasing a specific business. It determines how much equity a buyer will need and is the starting point for every SBA acquisition.

UCW is basically calculated by taking EBITDA and adding back in the owner’s salary, in the form of W2 income or management fees.  Next, the buyer draw, which is the money the buyer will take out of the business, is subtracted. Finally, this amount (EBITDA + Owner Salary – Buyer Draw) is divided by 12 months of loan payments. The resulting ratio, known as the “Debt Service Coverage Ratio”, is the first thing underwriters calculate when they look at a deal.

The problem many sellers run into is that they dilute their EBITDA too much with tax deductions. It’s not that this isn’t a good strategy, but it depends on what your end goal is. Deducting a whole host of expenses to reduce your tax burden also reduces your net earnings. In the end, your EBITDA has been reduced by two of the items that make up its total sum, earnings and taxes. If you are trying to sell your business in the near future, this could cause a problem where the UCW is not sufficient enough to cover the loan payments.

If you are considering selling your business soon, or have concerns about its eventual ability to sell, you can solve the EBITDA issue with proper exit planning. With adequate preparation time, a knowledgeable business broker can provide guidance on how to increase your EBITDA. Part of your strategy can also be to set aside more for your personal, W2 salary, since the owner benefit is added back in lender calculations. Creating a sound exit strategy can ensure that you are making the correct moves to increase your chances of selling successfully. Having the right advisor in your corner will help make the right moves and guide your decision making.

Choosing the right M&A advisor can make a tremendous difference in how quickly your business sells and the amount it sells for. If you own a business in the Sarasota, Fort Myers or Naples metro areas, Corporate Investment Business Brokers (CIBB) can meet all of your advisory needs. We have decades of proven success in helping Southwest Florida business owners prepare for the eventual sale of their businesses. We are committed to guiding our clients through the pre-sale process, even years in advance of listing their businesses for sale. Contact us for a free business valuation estimate and no-obligation consultation.