The EBITDA Enigma

The term EBITDA (earnings before interest, taxes, depreciation and amortization) is a metric measuring financial performance, embraced by many in the M&A community.  Yet, as a forensic accountant frequently called to assist attorneys in purchase price disputes, I have observed EBITDA at the heart of a large percentage of these matters.  These disputes seemingly occur due to confusion over EBITDA’s place in the transaction in question and the standard by which EBITDA is determined.

The Heart of an EBITDA Dispute         

It is not uncommon for Buyers to perform a number of calculations in the process of negotiating a purchase price for a target company.  In doing so, Buyers may perform business valuations, specific asset valuations, free cash flow projections, market analyses and even apply market multipliers to revenue, operating income, net income or “EBITDA”.   In a number of matters in which I’ve been engaged, Buyers have asserted reliance on either prior year or current year EBITDA as the basis for their negotiated purchase price.

EBITDA does not enter into the dispute typically unless the actual EBITDA experienced by the target company differs from the expected or projected EBITDA.  Consider the following scenario:

Buyer negotiates a purchase price for a target company based upon a five times (5X) multiplier of current year projected EBITDA.  At the time of the negotiations, current year EBITDA was projected to be $10,000,000, resulting in a negotiated purchase price of $50,000,000.  However, at the end of the current year, actual EBITDA was only $2,500,000. 

Instead of purchasing a $50,000,000 company, the Buyer asserts it purchased a $12,500,000 company and was defrauded of $37,500,000.  But, is this true?

This article is offered to explore this question.  A caveat – each dispute is driven by the actual facts and circumstances.  Additionally, the arbitrator, judge or jury has to weigh all of the evidence presented to determine whether EBITDA has, in fact, been relied on and whether EBITDA is relevant to the transaction at all.

The following is not intended to provide an exhaustive list of potential issues surrounding this question, but to alert both M&A counsel and litigators to matters that I, and others in my firm, have seen on more than one occasion.

EBITDA – Not a Defined Term

Continuing the above hypothetical situation, the Buyer brings a lawsuit against the Seller alleging fraudulent inducement and damages suffered as a result of the decreased EBITDA figures it purportedly relied upon in reaching the purchase price.  Despite this asserted reliance, “EBITDA” was not included in the purchase agreement as a defined term.  In fact, EBITDA was nowhere to be found in the purchase agreement at all. 

While EBITDA may have been absent from the purchase agreement, Buyers commonly argue their reliance based on a number of factors, including:

  • Discussions between the transaction parties about EBITDA;
  • Calculations of EBITDA transmitted between transaction parties; and
  • Discussions of multipliers to be applied to EBITDA observed in the market for similar transactions

In contrast, Sellers have asserted the irrelevance of EBITDA to the negotiations, agreed-upon purchase price and value of the acquired company, citing (among other things) that:

  • The purchase price was based upon perceived synergistic or investment value, rather than one year’s EBITDA;
  • There were a number of financial metrics discussed, of which EBITDA may or may not have been one; and
  • The reductions to current year EBITDA are irrelevant to the expected future cash flows of the company

Importantly, purchase price adjustments are used to ‘true up’ the consideration exchanged.  The methodology for applying the purchase price adjustments are typically defined within the purchase agreements.  Therefore, if EBITDA is the basis for such ‘true ups’ or for the original purchase price, the obvious and easiest way to avoid confusion is to include language within the purchase agreement denoting this fact.  Otherwise, Buyers and Sellers may end up where our hypothetical litigants are – litigating the relevance and importance of EBITDA in determining the agreed upon purchase price and related adjustments.

EBITDA is a Non-GAAP Measurement

Even if EBITDA is included within the purchase agreement for our hypothetical parties, a number of issues may arise.  While EBITDA is a commonly understood financial term, it is not one defined in GAAP.  Many purchase agreements include language defining GAAP as the accounting basis from which the purchase price, true-ups and earnouts must be calculated.  Since EBITDA is a non-GAAP measurement, disagreements may result.

EBITDA is commonly understood to be “earnings before interest, taxes, depreciation and amortization.  Yet, “earnings” may not be defined within the purchase agreement.  Though many may understand “earnings” to be net income, a GAAP term, the absence of such a definition can cause a myriad of issues, including:

  • What are “earnings”?;
  • Should “earnings” include non-recurring items, such as a one-time windfall sales figure, or conversely, a one-time hit to income?;
  • Should “earnings” be adjusted for anticipated saved costs that will not be incurred in the future due to the acquisition synergies?; and
  • What interest should be added back in calculating EBITDA (many times factoring costs, loan interest and pension-related interest are reported separately and differently in the income statement)?

The use of a non-GAAP measurement, such as EBITDA, can be confusing.  The SEC warns of this risk in its Accounting and Disclosure Rules and Practices – Topic 8:  Non-GAAP Measures of Financial Performance, Liquidity and Net Worth,   I. Disclosure of Non-GAAP Measures Such as Earnings before Interest, Taxes, Depreciation and Amortization (“EBITDA”), stating, “some registrants choose to present a non-GAAP financial measure such as EBITDA or FFO (funds from operations) in their disclosure documents. Although such measures can be useful in some circumstances, an unbalanced presentation can be confusing and lead to undue reliance on the measure by investors.”

When applying a multiple to current year EBITDA, the assumption ordinarily is that current year financial performance is indicative of the future prospects and performance of the company.  In the instances described above, regarding non-recurring items or saved costs, current year EBITDA may differ from the next year’s EBITDA simply due to the occurrence of these one-time events or saved costs.  Thus, there is a question of how to adjust or whether to adjust for these items.  Given the potential confusion of EBITDA and its many complexities, M&A counsel can provide great value to his/her clients by either including definitive language within the purchase agreement or advising them of the associated risks.

Historical EBITDA vs. Future Performance

During the due diligence process, forensic accountants are often used to investigate certain financial aspects of the company.  Likewise, valuation specialists can be utilized to examine the future expected cash flows, research the comparables of other transactions in the market in which the company operates and calculate the fair value of the target company.

Most transactions are accomplished based upon a negotiated price.  As discussed above, negotiations tend to consider the perceived synergistic value of the deal, meaning Buyers consider saved costs, eliminated competitive threats and future growth prospects.  Thus, the application of a multiple to historical EBITDA without such adjustments may result in skewed results.  In addition, in a high growth environment (i.e., younger company on steep growth curve), the application of a multiple to historical EBITDA may not be the best indicator or measurement of future performance, unless the multiple takes into consideration relevant risks and growth potential.

Additional Remarks

When entering into a transaction, both parties, Buyers and Sellers, are often optimistic and overlook the potential pitfalls ahead.  When the perceived outcome of any transaction is less than the desired results, the disappointed party will naturally look for reasons why.  To the extent that EBITDA will play any role in your client’s purchase price determination or measurement of success, addressing the potential issues discussed above prior to closing or within the purchase agreements may mitigate the risk of future litigation.


Karen Fortune, CPA/CFF, MAcc – Partner

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IAG Forensics

IAG Forensics & Valuation is a CPA firm that specializes in forensic accounting, fraud investigation, business valuation and litigation support.

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