How adjusted EBITDA is calculated
Start from reported operating profit, add back depreciation and amortisation to reach EBITDA, then make normalisation adjustments. Each adjustment has to answer one question: would this cost or income exist under a new owner running the business in the ordinary course?
Adjustments run in both directions. A founder paying themselves below market rate creates a negative adjustment, because a buyer will need to hire a replacement at the market salary. Sellers who only present upward add-backs lose credibility quickly in diligence.
- Owner compensation above or below a market-rate replacement salary
- Genuinely one-off costs such as litigation, a failed fundraise or a relocation
- Non-cash items such as share-based compensation (buyers increasingly contest this in software deals)
- Personal or non-business expenses run through the company
- Related-party rent or services priced away from market rates
- Run-rate adjustments for cost savings or price rises already implemented but not yet reflected in the trailing twelve months
Why each add-back is worth a multiple of itself
Enterprise value in a mid-market deal is usually adjusted EBITDA multiplied by a sector multiple. Every dollar of accepted add-back is therefore worth the multiple, not a dollar. At a 6x multiple, a $150,000 owner salary normalisation adds $900,000 to headline value. The same arithmetic works in reverse: a rejected add-back costs the seller the multiple.
This is why add-backs are the most negotiated line in a transaction and why buyers commission independent quality of earnings (QoE) work to test them.
What buyers accept and reject
Add-backs supported by invoices, board minutes and a clear one-off narrative are usually accepted. "Recurring one-off" costs that appear every year, pro forma synergies the buyer would create, and projected savings that have not been implemented are routinely rejected.
A useful test: if the seller cannot evidence an adjustment in a single page with source documents attached, expect it to be discounted or removed in the QoE report.
Adjusted EBITDA versus SDE
Adjusted EBITDA assumes the business is run by paid management, so it only adds back owner pay above a market salary. Seller’s discretionary earnings adds back the whole of one owner’s compensation, which makes SDE the better measure for small owner-operated businesses and adjusted EBITDA the standard for businesses with a management layer.
Worked example
| Line | Amount (USD) |
|---|---|
| Reported EBITDA | 2,000,000 |
| Owner salary above market replacement | +150,000 |
| One-off litigation settlement | +80,000 |
| Below-market related-party rent | -40,000 |
| Adjusted EBITDA | 2,190,000 |
| Enterprise value at 6.0x reported EBITDA | 12,000,000 |
| Enterprise value at 6.0x adjusted EBITDA | 13,140,000 |
Frequently asked questions
- Is adjusted EBITDA a GAAP or IFRS measure?
- No. Adjusted EBITDA is a non-GAAP measure. There is no standard definition, which is why the purchase agreement and the QoE report should set out exactly which adjustments were agreed.
- Should share-based compensation be added back?
- Sellers often add it back because it is non-cash. Many buyers of software businesses now treat it as a real cost, because the equity has to be replaced with cash compensation after the deal. Expect it to be negotiated.
- How does adjusted EBITDA affect debt financing?
- Lenders size senior debt as a multiple of EBITDA, usually their own adjusted figure. Aggressive add-backs that a lender rejects can shrink debt capacity and leave a funding gap the buyer has to fill with equity.
See every term in the Acquiry M&A Glossary. Last reviewed .