Last week’s nugget discussed the most common appraisal methods used to value a target. One of those methods is the capitalization of EBITDA. In calculating the target’s earnings that will be used to determine value, buyers and appraisers typically smooth-out earnings, that is, re-compute earnings to eliminate nonrecurring or extraordinary items. One of the most common adjustments made to earnings is to add back the excess of actual owner compensation over what would be standard compensation paid to a person with the owner’s responsibilities. Casualty losses in a business that do not routinely suffer those losses are often added back to earnings. Unusual litigation with high cost may also be added back. Certain items may be deducted from earnings. For example, manufacturers’ rebates substantially higher than the historical norm may be deducted from earnings. It is important for both sides in a transaction to understand the smooth-out process for earnings, so that they will have a realistic expectation of value.
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Glenn D. Solomon is a principal at Offit Kurman and has provided counsel to businesses and business owners for more than twenty-five years. He has extensive experience in the purchase and sale of businesses, structuring ownership agreements, and advising companies in financial distress.
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