Understanding Profitability & EBITDA
“How profitable is the business?” Though a simple question, it is one with critical implications. While most software founders and executives have some understanding of their company’s profitability, many of our clients are generating more profit than suspected. Accurately understanding earnings is paramount in communications with shareholders, team members, and potential investors, especially when considering a transaction. Knowing what to look for can be the difference between losing money and generating a profit, which has real dollar implications.
EBITDA, an acronym for “Earnings Before Interest, Corporate Taxes, Depreciation, and Amortization,” is synonymous with “profitability”. EBITDA is a measure of a company’s earnings and is used in conjunction with revenue, cost of goods sold/gross profit margin (see more about calculating COGS here), and net income to assess a company’s overall financial performance.
How to Calculate EBITDA
To calculate EBITDA, simply take the net income of the business and add the following:
- Interest expense
- Depreciation expense
- Amortization expense
Easy, right? Now, here’s where it gets interesting. There are additional expenses that can be considered when analyzing profitability. These are referred to as EBITDA Adjustments (also known as Add-Backs).
EBITDA Adjustments (AKA Add-Backs):
EBITDA Add-Backs are expenses not expected to be part of the business going forward or are not typical expenses historically. These can include any one-time, non-recurring expenses, as well as expenses that would no longer be incurred if the business were acquired. These include, but are not limited to:
- Non-recurring legal expenses
- Non-recurring labor expenses (recruiting, severance)
- One-time project expenses (web redesign, system rewrite)
- Personal/lifestyle expenses incurred by owners/executives
- Above market compensation for executives (market rate is considered $200-300K per year, any compensation above is added back)
- Profit sharing expenses for employees not expected to continue with the business
- Engineering and development expenses on a new product that has generated little to no revenue
Company A has $5 million of revenue with $5.5 million in total expenses, which results in net income of ($500,000). They have $500K total in interest expenses, depreciation, and amortization. This results in an EBITDA of $0, which translates to an EBITDA margin of 0% (($0/$5 million), indicating a breakeven business. In addition, there are the following expenses:
- $1.5 million in compensation going to three key owner-operators
- $300k recruiting expense to hire a new head of marketing and head of sales
- $50k one-time web redesign expense
If we assume that, in a scenario where the business is acquired, the three key owner operators will exit and it is determined they need to be replaced at salaries of $250K each, then EBITDA is adjusted by:
- Adding back $750K of above market compensation
- Adding back $300K recruiting expense
- Adding back $50K one-time web redesign expense
Total Add-Backs: $1.1 Million
Adjusted EBITDA (EBITDA + Add-Back Amount): $1.1 Million (22% EBITDA margin)
By analyzing the company’s expenses and determining the appropriate add-backs, it is shown that the adjusted EBITDA is $1.1M (22% EBITDA margin) as opposed to $0 (0% EBITDA margin). This represents a significant increase in profitability over the original breakeven EBITDA, and greatly alters the way the financial performance of the business can be presented.
Why Calculating EBITDA is Important for Investors
To make it crystal clear, because EBITDA is a measurement of profitability. However, EBITDA alone does not show overall financial worth. Many other factors do, too: EBITDA is a measure of a company’s earnings and is used in conjunction with revenue, cost of goods sold/gross profit margin, and net income to assess a company’s overall financial performance.
Buyers and investors primarily look at EBITDA to review a company’s profitability. Oftentimes small SaaS companies have negative EBITDA, but still have positive cash flow. This is because SaaS companies collect bookings upfront. An example of this would be collecting an annual payment upon selling a product as opposed to charging a customer 1/12 of the payment every month. For companies that are growing, cash flow doesn’t necessarily accurately reflect future performance.
EBITDA margins in SaaS may not look too great. This is why buyers often also look at the Rule of 40, outlined in detail in our “18 Factors You Need to Track When Valuing Your SaaS Company” white paper, which compares EBITDA and revenue. If a company isn’t very profitable, they may be investing in their growth. This also works the opposite way. If a company lacks growth, they might be more profitable already. (This is usually indicative that they are a larger company that is slowing the rate at which they are scaling.) Once those small companies scale, they can improve their EBITDA.
Rest assured: a low EBITDA margin won’t necessarily have a severe negative impact on your valuation. However, buyers do tent to look more closely at SaaS companies with margins of 30% or greater.
AT SEG, we use our 30+ years of experience in M&A advisory services to prepare our clients for a liquidity event now, or down the road. If you have any questions about calculating EBITDA and add-backs, please don’t hesitate to reach out to SEG.