TVG

"The business seems to have a consistent annual EBITDA around $800,000, so I think it is probably worth about $3.5 million."

 Michelle (not her real name) called me on the advice of her uncle to help her think through the logic of acquiring a business. She had just relocated to Nashville to follow her husband, who is a physician in the Vanderbilt healthcare system. "I've always wanted to buy and run my own business--my dad did that, and I guess I'm following in his footsteps," she told me when we first spoke. She found this opportunity through networking around town, and at first glance, it seemed to meet many of her objectives. I could tell she was excited.

 But it didn't take long to dampen her enthusiasm when I explained the dangers of valuing a small business solely on the basis of EBITDA. "But everyone I talk to refers to EBITDA--I thought that's how these things were done," she said.

 I walked her through two reasons why I am skeptical of EBITDA. First, EBITDA does not capture how cash actually moves through the business. For example, it does not account for capital expenditures necessary to run the business, nor does it give any insight into the vagaries of working capital.

The second problem relying on EBITDA is that financial records of small businesses are generally not GAAP compliant (Generally Accepted Accounting Principles). Therefore, EBITDA doesn't tell you how revenue is recognized, whether cost of goods sold properly matches recorded revenue, or if the business reserves adequately for warranties and/or collection deficiencies.

 The late Charlie Munger once said, "Every time you hear EBITDA, substitute it with BS earnings" (except he used the actual word). Munger and his partner, Warren Buffett, are legends for finding great businesses, and Buffett always says the best way to evaluate a business is based on free cash flow.

With this in mind, I suggested to Michelle that she ask for a sources and uses of cash report from the company, or, if that isn't available, obtain three or four years of monthly bank statements. This will allow her to evaluate deposits and withdrawals to see how money really moves through the business. This is the only way Michelle can be certain the business generates enough cash to cover debt service, capital expenses, fund growth, pay her salary, and provide a good return on her invested capital.

Just remember, while EBITDA is a shorthand way of looking at a financial statement, you can't pay the bills with "BS earnings."

 

Tennessee Valley Group

Jim is an attorney (non-resident status with the Missouri Bar) and though he no longer practices law, he has read and negotiated enough legal documents to fill a cargo tanker. He has an MBA from Harvard Business School and knows how Wall Street and private equity operates. Jim is a Tennessee Supreme Court Rule 31 listed general civil mediator with tons of experience helping business owners (large and small) work through sensitive problems to achieve winning results. He is the author of "Home Run, A Pro's Guide to Selling Your Business, Seven Principles to Make Your Company Irresistible."