Adjusted EBITDA Explained for IT Service Providers

Any business owner who tracks their books knows how valuable EBITDA (earnings before interest, taxes, depreciation, and amortization) can be. EBITDA measures core (or operating) business profitability, before debt, taxes, or asset maintenance come into play. Even though EBITDA is not part of GAAP, it’s almost universally included in income statements because it helps external parties better understand how a business is performing. Knowing EBITDA answers a critical question — is this a fundamentally good business? 

If EBITDA is negative, for example, it tells you that the business has serious operating issues. It might be spending too much on marketing to attract new customers, having too few customers to cover fixed costs, or even not charging enough to offset variable costs for each customer. 

That said, positive EBITDA doesn’t mean a business is profitable, especially if it spends a lot on CapEx to operate. 

Still, EBITDA is routinely used in the business community to compare company valuations, usually expressed as a multiple. A growing technology company might sell for anywhere from 3 to 10x EBITDA. Large companies with a significant moat (e.g. proprietary technology) might expect even higher multiples of between 10 and 15x or more. 

While EBITDA tries to get to the core performance of a business by subtracting non-operating expenses, there still might be some non-recurring expenses that muddle the picture. Subtracting those can help clarify business performance even further — in a metric called adjusted EBITDA. 

What Is Adjusted EBITDA?

Adjusted EBITDA drills down further to analyze the core operating business by adding back additional one-off expenses or subtracting non-operating income – COVID-related loans for example. The expenses can vary widely and include debt write-offs, employee bonuses, legal expenses, COVID-related spending, etc.

Unlike EBITDA, adjusted EBITDA varies for every company. Knowing how to calculate it properly (and reasonably) for your business can be the difference between being valued at a lower or higher multiple in an acquisition or investor negotiations. 

That’s why adjusted EBITDA is crucial for IT service providers that are looking to sell their business or bring in external investors. Getting the adjusted EBITDA right can increase the company’s valuation by a whole multiple (or more) — meaning hundreds of thousands or more added to the purchase price. 

Common EBITDA Adjustments for IT Service Providers

Although adjusted EBITDA is different for each company, there are still common adjustments that tend to be used by most IT service providers. 

Note: EBITDA adjustments can both increase and decrease the value of your company. While they are more likely to do the former, it’s important to be clear truthful, and reasonable, so others can see how your business really works.

Here are just a few typical EBITDA adjustments you’ll see ISPs make. 

Adjustments for non-recurring expenses:

  • One-time bonuses for the owner or employees
  • Excessive travel for conferences or business that includes elements of personal expenses – ex a boat tour or rounds of golf, etc
  • Legal expenses in cases where the company was sued or is suing another party
  • One-off corporate events 

Adjustments for non-operating income or expenses: 

  • Above or below market salaries for owners
  • Above or below market salaries for employees (oftentimes these are family members)
  • Non-operating real estate, vehicles, boats, etc.
  • Personal insurance including health for extended family 
  • Charitable contributions

Adjustments for non-cash items: 

  • Stock-based compensation for employees
  • Excessive depreciation or amortization 
  • Asset write-downs
  • Deferred taxes

Adjustments for changes in working capital: 

  • Non-recurring investments into operating capacity
  • A one-time sale of assets (ie generating non-operating income)
  • Expenses or income from a related company
  • Rent adjustments below or above market

Additionally, the COVID-19 pandemic has added lots of one-time expenses that could obscure the true health of the business: 

  • Changes in IT infrastructure for remote workers
  • Discounts for customers who couldn’t pay the bills
  • Lease terminations
  • Sales of office furniture
  • Severance for laid-off employees
  • Additional legal costs
  • Provisions for future losses

How Adjusted EBITDA Is Used by IT Service Providers

As mentioned above, while adjusted EBITDA is not a strict accounting metric, it helps outsiders (e.g. financial analysts) evaluate the core of the business without unusual gains or expenses. Adjusted EBITDA growth over a few years, for example, shows that the core business is in a good place and makes forecasting easier. 

In turn, this gives potential acquirers a solid base from which they can calculate the company’s valuation based on growth and future returns, without being distracted by extraordinary events, such as the COVID-19 pandemic. 

Since EBITDA and adjusted EBITDA are common industry metrics, they are often used for benchmarking and comparing different IT firms. If one company’s adjusted EBITDA margin is 40% and another one’s is 30%, we know that the former is more efficient and can take a closer look at its financials. 

Adjusted EBITDA Shows Healthy Business Growth

It’s easy to be swayed by one-off gains and happily book large increases in profitability. But why rely on lottery tickets and external events? 

Adjusted EBITDA helps keep the business grounded, growing its core operations, which results in more realistic and resilient measurements over the long term. 

Not sure where to start with adjusted EBITDA? Contact the Host Broker, and we’ll guide you through the process — and even give your business a free evaluation.

Know more about your business and how it performs compared to your industry peers by connecting with us today!