Since most businesses are purchased as a multiple of earnings (expressed as EBITDA), the seller has substantial motivation to get those earnings as high as possible before they put their company up for sale.
This focus on earnings is a normal function of everyday operations for any successful business.
However, since every dollar added to EBITDA can bring back a substantial return in valuation through a sale – often 7X, 8X or higher – sellers are particularly eager to put dollars on the EBITDA line, especially in the trailing 12 months before a sale.
The trailing 12 months (TTM) is often the “operative time frame” during which a multiple of EBITDA is applied by an acquirer to determine a sale price.
Most prospective acquirers expect to see this pattern of selling on an earnings uptick. It’s only natural; any company owner who tried to sell at a low point in the business cycle would be looked upon with suspicion, and accordingly, the firm would receive a poor valuation. That said, investors or acquirers considering a deal at times of peak earnings have the right to question two things:
- The quality of those earnings.
- The sustainability of those earnings in the future.
Quality of Earnings
Simply stated, the quality of the earnings is an indication of how likely the earnings are to continue. High-quality earnings don’t necessarily have to show up on your books as repeat business, although that is certainly desirable since repeat business costs the least to acquire. High quality can also mean consistent new-customer acquisition (assuming good EBITDA margins) or consistent rates of increase, year to year, whether the source is repeat business or new business.
High-quality earnings not only lead to healthy cash flow, but they also point to a quality sales staff and a disciplined company that works hard to take care of its customers while always looking for new ones.
For example, say a business shows sales of $25 million three years ago, $27 million two years ago, $29 million last year and a prediction of $31 million this year. The company has consistently shown 10% EBITDA margins, with an unadjusted EBITDA of $2.5 million, $2.7 million and $2.9 million, respectively, and a projection of $3.1 million this year.
A prospective buyer looking at that company will have no problem believing the current fiscal year’s projections of $31 million – even with just a few months of data to go on – because the earnings have shown consistent, high-quality growth.
If another business were to show jagged sales and EBITDA margins that bounce around from year to year with no symmetry, followed by a killer year of strong sales and high EBITDA margins (coincidentally getting ready for a sale?), the potential acquirer isn’t going to have a great deal of faith in a recent, spectacular 12-month period.
That’s because the recent numbers may not represent a trend that will continue. In fact, that recent performance may represent only a “sugar high” that can’t be consistently replicated.
Red flags will – and should! – pop up on the deal. Candidly, valuation shouldn’t be based on the trailing 12 months but, perhaps, on earnings averaged out over the past three years – or as long as the company has been in business, if it is younger than that.
Sustainability of Earnings
The sustainability of earnings indicates the likelihood that current earnings will continue to grow or keep pace at roughly the same rate as the cost of goods sold (COGS) expenditure levels.
It’s even more impressive if you can show that you can sustain or increase your earnings while lowering COGS over time, indicating that you are always working to drive up efficiency.
If a business owner had a great year but knows in his or her heart that the company will have to increase marketing costs, support personnel and sales force salaries the following year to retain customers, then the sustainability of the earnings is lower, and customer retention may be more volatile than current earnings indicate.
The same principle holds for a seller who positions his or her company for sale by making an effort to suppress COGS. Some examples include:
- Deferring necessary maintenance.
- Not buying necessary new equipment or modernizing existing equipment.
- Not filling a position that needs to be filled.
- Misallocating expenses into a different time period than the allocation of earnings just to obtain an earnings credit that really should be an expense.
These examples are remarkably common.
A prudent buyer or investor will examine the seller’s COGS along with the seller’s maintenance schedules, historical staffing levels and future staffing needs to see how they have changed over time with respect to your earnings.
If you reported earnings that you have yet to collect (e.g., pending accounts receivable) and you are using an accrual – as opposed to cash -accounting basis, you will have credited those to EBITDA.
The prospective acquirer will be within his or her rights to question whether those reflect accurate earnings, especially if there is a history of bad pays that have not properly been accounted for in your bad debt allowances.
There is no trick to reporting the quality and sustainability of earnings. It’s about divulging what’s fair and reasonable, properly allocating earnings and expenses and forthrightly calculating COGS in a way that an acquirer and seller agree is accurate.
John D. Wagner and Dr. Carl Craig are managing directors of Colorado-headquartered 1stWest Mergers & Acquisitions, which offers a specialty practice in the marijuanas and hemp sectors. 1stWest M&A has transacted more than $1 billion in deal values.