The definition earnings before interest, taxes, depreciation and amortization (“EBITDA”) and adjusted EBITDA have always been important and highly negotiated pieces of credit agreements and M&A transactions. However, with the unprecedented economic impact of the COVID-19 pandemic, these financial measurements take on even greater importance as borrowers seek to maintain financial covenants in their credit agreements and prospective buyers and sellers struggle to determine whether EBITDA, if determined without an adjustment for the financial impact of COVID-19, will provide an accurate representation of a company’s value. One example of this in M&A transactions, where a multiple of EBITDA is a common valuation technique for determining the purchase price in M&A transactions. During COVID-19, certain businesses are flourishing due to increased revenues (e.g., health care or residential waste haulers). In this situation, buyers may ask to adjust EBITDA downward to remove the impact associated with the COVID-19-related revenue increase, thus driving the purchase price down.
Overview of EBITDA and Adjusted EBITDA
EBITDA is one of the most commonly used non-GAAP measurements of earnings. While generally the inputs are based on GAAP principals, the term itself is not defined in GAAP. Adjusted EBITDA is calculated by adding or subtracting certain expenses to and from EBITDA in order to provide a clearer picture of a company’s profitability and to make it easier to compare a business from year-to-year and to its industry competitors.
Gross Operating Revenue
– Operating Costs and Expenses
= Consolidated Net Income
+ Interest Expense
+ Income Taxes
+ Depreciation and Amortization
+/- Permitted Adjustments and Addbacks
= Adjusted EBITDA
EBITDA and Adjusted EBITDA in Lending Transactions
EBITDA is an important measure in lending transactions as it is often used by lenders to evaluate whether borrower has sufficient cash flow to service the loan. The definition of Adjusted EBITDA is a highly negotiated term in a loan agreement. Most loan agreements typically allow for addbacks to EBITDA for “extraordinary, non-recurring and unusual costs, expenses and losses.” These terms are usually not defined in credit agreements but instead are interpreted based on GAAP principals and commonly accepted definitions of these terms.
- “Extraordinary” is no longer defined in current GAAP authority; however, under prior authority, a cost arising from an event or transaction was “extraordinary” if the underlying event or transaction was (i) unusual (discussed below), and (ii) infrequent (not frequently expected to be incurred in the foreseeable future).
- “Unusual” is defined by GAAP authority as an underlying event or transaction that “possesses a high degree of abnormality and is of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates.”
- “Non-Recurring” is not defined in GAAP. A commonly accepted definition is found in the SEC’s rules and regulations regarding the use of non-GAAP financial measures in public filings. These rules provide that an expense is “non-recurring” if the expense is caused by an event or transaction that has not occurred within the most recent two years and is not expected to recur within the following two years.
The following is a non-exhaustive list of potential COVID-19 related expenses that may be negotiated as addbacks in determining Adjusted EBITDA.
- Technology expenses relating to facilitating remote work, including software and license fees
- Additional printing, shipping, and delivery expenses incurred to facilitate working from home
- Costs related to cleaning and disinfecting facilities more frequently or more thoroughly, as required by local and state orders
- Costs to purchase face masks for employees and customers and hand sanitizer
- Hands free thermometers and COVID-19 tests for in-office employees and visitors.
- Termination fees and other expenses relating to cancelling contracts and events
- Incremental training and IT expenses incurred from transitioning employees to working from home and, subsequently, bringing them back to the office
- Temporary incremental employee and contractor pay increases for high-risk jobs
- Expenses relating to additional time off (paid and unpaid FMLA) for COVID-19 related reasons (including employees who take off time for childcare, taking care of sick persons in their family, or for their own sickness)
- Additional professional fees relating to reliance with COVID-19 local and state orders and CARES act loans (including PPP loans)
While there are a number of expenses that may be added back in determining adjusted EBITDA, there are limitations. Many businesses may find that their biggest COVID-19 loss is related to lost revenue. Unfortunately lost revenue is very unlikely to be a permissible addback. The concept of “lost revenue” does not exist in GAAP, and a number of GAAP authorities explicitly provide that lost revenue is not a permissible addback. Additionally, the SEC recently published guidance, which reaffirmed that lost revenue should be not presented in financial disclosures.
Additionally, the SEC provided guidance that expenses where are not incremental to and separable from normal business activities are not permissible addbacks in financial disclosures. Examples of these include paying for temporarily idle employees or facilities in compliance with state and local orders.
EBITDAC and M&A Transactions
If you have not heard of EBITDAC (EBITDA plus a “c” for coronavirus), you might soon. The emerging acronym was allegedly first used by Schenck Process LLC, a German applied measuring technology company owned by US-based private equity firm Blackstone, reportedly added back 5.4 million euros to its earnings (the amount it claims it would have earned but for the pandemic). So what does a coronavirus adjustment include? Unlike EBITDA addbacks, which are based on GAAP and other commonly accepted guidance, EBITDAC can be whatever a company wants or, in the case of M&A transactions, whatever the parties negotiate. For example, while lost revenue is unlikely to be a permitted addback in a credit agreement and is explicitly prohibited for SEC reporting purposes, it may be useful and appropriate when calculating EBITDAC for purposes of determining the purchase price of a business in an M&A transaction.
While many analysts say that EBITDAC can be a misleading financial metric, others argue that not making a COVID-19 adjustment to account for the pandemic’s impact on a business can be even more misleading. In any case, while EBITDAC is not allowed in GAAP financials or in public company filings, we expect to see coronavirus adjustments to EBITDA in future private M&A transactions.
Potential Uses for EBITDAC in M&A Transactions
- Purchase Price: A multiple of EBITDA is a common valuation technique for determining the purchase price in M&A transactions. Many businesses have seen dramatic changes to their EBITDA (some positive, some negative) as a result of the pandemic. Using a trailing 12 or 24 month EBITDA without a coronavirus adjustment (such as a lost revenue adjustment as discussed above, or an adjustment to account for temporarily increased revenues) could dramatically overstate or understate the value of a company.
- Earnouts: Earnouts are often based on hitting pre-defined EBITDA targets. A coronavirus adjusted EBITDAC may be more appropriate for targets that are based on a percentage increase over a pre-closing period that includes a period where the business had a significant economic impact from COVID-19.
- Executive Compensation Agreements: Similar to earnouts, executive compensation arrangements often use EBITDA targets as triggering events for compensation. Agreements with targets based on increases from COVID-19 impacted periods may need an adjustment to baseline EBITDA figures to appropriately account for coronavirus economic impacts.