What does adjusted EBITDA actually mean?

Start with the plain version

EBITDA stands for earnings before interest, taxes, depreciation and amortization. The idea is simple: strip out the things that vary because of how a company is financed, how it is taxed, and how old its equipment is, so that two businesses can be compared on how much cash the operations actually throw off.

Interest comes out because the buyer will use their own financing. Taxes come out because the buyer's tax position will be different from yours. Depreciation and amortization come out because they are accounting entries rather than cash leaving the business this year.

Then comes the word 'adjusted'

Very few privately held companies are run to maximize reported profit. They are run to support a family, minimize tax, and give the owner a reasonable life. That is entirely rational, and it means the profit on your tax return understates what the business would earn in a buyer's hands.

Adjusted EBITDA is the attempt to correct for that. You add back expenses a new owner would not carry, and you subtract costs the business will have to bear that it does not show today. The result is a picture of normal, ongoing earning power.

This is where most of the negotiating happens, because every dollar you add back is multiplied. At a six times multiple, a $50,000 add-back a buyer accepts is worth $300,000 of purchase price. One they reject costs you the same amount.

Add-backs buyers generally accept

Owner compensation above market rate. If you pay yourself $400,000 and a hired general manager doing your job would cost $180,000, the $220,000 difference is a legitimate add-back. Note that the add-back is the excess, not the whole salary.

Personal expenses run through the business. Vehicles that are not used for work, family members on payroll who do not work in the company, personal travel, club memberships. These are common and buyers expect them, as long as you can document each one.

Genuine one-time costs. A legal settlement that will not recur, a flood, the cost of a failed software implementation you have abandoned. The test is whether a buyer believes it will never happen again.

Rent above market. If the company pays your own real estate holding entity above what the space would rent for, the difference is an add-back, because the buyer will negotiate a market lease.

Discontinued lines of business, where you can show the revenue and the costs separately and cleanly.

Add-backs buyers argue about

Anything you cannot document. An add-back you assert but cannot evidence with an invoice, a payroll record or a contract will be removed. This is the single largest source of lost value in diligence, and it is entirely preventable.

Recurring 'one-time' costs. If you have had a one-time legal expense in each of the last four years, a buyer will conclude that legal expense is simply a cost of your business.

Deferred maintenance and capital expenditure. If you have not replaced trucks in six years, a buyer will not let you add back the savings. They will do the opposite and deduct the catch-up spending.

Growth investments you claim you would not repeat. Buyers tend to view marketing and hiring as ongoing, not optional.

Family members who do some work. Half a job is not a full add-back, and this gets negotiated line by line.

What a buyer does with the number

In a real process, the buyer will not simply accept your adjusted EBITDA. They will commission a quality of earnings report from an accounting firm, which tests each adjustment and produces their own figure.

The gap between your number and theirs is negotiated, and it is negotiated after you have signed a letter of intent, when your leverage is at its lowest. This is why the strongest thing an owner can do is have the analysis done properly on their own side first, before going to market.

An owner who arrives with a defensible schedule, evidence attached to every line, holds their number. An owner who arrives with a spreadsheet of assertions watches it shrink.