The last post explored the EBITDA Trap. The EBITDA Trap is notion that when one purchases a company the price is based, typically, on a multiple of EBITDA – which is shorthand for Gross Cash Flow. However, as buyer you are ONLY concerned with Free Cash Flow. To reiterate one acquires a company based EBITDA (Gross Cash Flow) and in return is entitled to Free Cash Flow. Read previous posts regarding the definition of EBITDA and Free Cash Flow.
The key to avoiding the EBITDA Trap is insuring that Free Cash Flow is adequately provided for. Please see “Financial Analysis” page. The first step is analyzing Free Cash Flow under differing circumstances. In addition to the financial analysis one must adequately address: 1) purchase price 2) company’s future prospects 3) macro-economic concerns 4) management’s ability to operate the business and 5) capital structure.
For now however we are exploring an analysis of Free Cash Flow and will address other issues in later postings. The following example is a company with an EBITDA of $100 and the following characteristics: 1) selling price of 4x EBITDA or $400 2) acquired with $200 of debt – payable over five years at an interest rate of 8% and 3) a 40% tax regime. Note that the any one of the five items that can affect the Free Cash Flow of the business.
The example simply indicates that Free Cash Flow can limit or expanded by 1) revenue (or expense) changes and 2) capital structure – re: payback of loan and interest. Implied are the other factors noted in paragraph 2. Hence, one can avoid the EBITDA Trap by attending to 1) purchase price 2) capital structure 3) future prospects of the business (as well as macro and management issues) and having a CLEAR UNDERSTANDING OF THE EXPECTED CASH FLOWS.
Purchase price is correlated to the ability of the company to generate cash. So while the seller is asking for a multiple of EBITDA – the buyer must get a firm handle on the company’s prospects in order to assign a multiple that makes economic sense. A deeper dive next time.