Agency owners are like gossiping kids, always asking and telling what the latest multiple of EBITDA their agency’s value is. But they never ever discuss the EBITDA. Let's say the multiple is 6. Then it is 6 times EBITDA, but what is the EBITDA? Three, at least three, different kinds of EBITDA exist, and it pays to know which EBITDA is being multiplied.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The idea is to identify cash flow excluding financing effects (if you want to identify true cash flow including financing effects such as loan repayments and interest, use "free cash flow" which is a better measure of value anyway). However, EBITDA has now been bastardized in so many different ways that there is even disagreement as to what the "E" for Earnings represents. Different people use different numbers for the same firm's "E". I find that almost no agency owner understands how the EBITDA formula actually works in the real M&A world. Here then are three examples, and by no means are these comprehensive in variety or detail.
EBITDA #1, Actual EBITDA -- Actual EBITDA is your actual, unadjusted EBITDA. For example:
Agency’s Actual, Unadjusted Numbers
Commissions
$1,000,000
+Contingency
$100,000
-Compensation
$600,000
-Sales Expenses
$50,000
-Administrative Expenses
$200,000
+Interest
$10,000
+Taxes
$20,000
+Depreciation
$20,000
+Amortization
$40,000
Actual EBITDA
$330,000
Your actual, unadjusted EBITDA IS NOT the EBITDA upon which your value is determined! The EBITDA used is an adjusted EBITDA if the valuation is done correctly.
EBITDA #2 -- Pro Forma EBITDA adjusted for the sale to a large buyer:
Agency’s Actual, Unadjusted Numbers
Commissions
$1,000,000
+Contingency
$130,000
-Compensation
$500,000
-Sales Expenses
$50,000
-Administrative Expenses
$250,000
+Interest
$30,000
+Taxes
$10,000
+Depreciation
$20,000
+Amortization
$80,000
Actual EBITDA
$470,000
If you sell for 6 x $330,000 rather than 6 x $470,000, then you leave 6 x $140,000, or $840,000 on the table.
EBTIDA #3 -- Pro forma EBITDA for a strict Fair Market Value situation:
Agency’s Actual, Unadjusted Numbers
Commissions
$1,000,000
+Contingency
$100,000
-Compensation
$500,000
-Sales Expenses
$50,000
-Administrative Expenses
$180,000
+Interest
$10,000
+Taxes
$20,000
+Depreciation
$20,000
+Amortization
$40,000
Actual EBITDA
$450,000
These are just examples and should not be taken as literal in any way whatsoever. My point is that not only is each agency's EBITDA different, but the EBITDA for each agency must be different for each kind of buyer. Not knowing the applicable EBITDA renders the multiple irrelevant. For example, I once saw an agency brag about selling for 11 times EBITDA. Their actual EBITDA was, let's say $1,000,000. They were paid $11,000,000. Their pro forma EBITDA, the EBITDA that actually mattered, was $1,800,000. They actually were paid a less than normal price, but they did not know it.
On the other hand, some owners see the big EBITDA dollars after a buyer or some consultant has worked through the agency’s numbers. They take the results to a bank and expect the bank to loan on that grossed up profit margin for an internal sale. Do not do this. You will only embarrass yourself because banks, at least those knowing what they are doing when loaning to an agency, typically only use the strict Fair Market Value EBITDA, not the larger EBITDA calculated when selling to private equity and publicly traded brokers.
The adjustments are different depending on the type of buyer. Compensation is often a huge difference because many buyers only pay 20%-25% renewal commission and then exclude any commission on accounts generating less than $X (and that $X can be large). Producer compensation reductions are not usually as large in other scenarios. Also, those big buyers are usually making extra money in a myriad of ways that regular buyers will not make. They also get favorable financing.
Valuations based on EBITDA sound simple, even alluringly sophisticated, but still simple enough for everyone to understand. Quality valuations using EBITDA are complex. Oversimplification serves business brokers and specific buyers well while injuring the sellers. Oversimplification can cause less knowledgeable sellers to make mistakes.
Because EBITDA calculations are so easy to manipulate and even disguise the manipulation, the U.S. Securities and Exchange Commission has warned against using EBITDA. Many academic studies show firms using EBITDA have numbers that should be viewed more carefully because, the authors conclude, some such firms may be abusing this method.
Not being taken advantage of is important. One really needs to know which of the three major kinds, much less the various deviations, of EBITDA to apply to your specific situation. I strongly recommend hiring an advisor who specializes in this area and is not a business broker to advise you if your local accountant is not steeped in insurance agency valuations.
NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.