Understanding EBITDA for Consulting Leaders

Key Takeaways

• EBITDA Overview: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is vital for comparing profitability in consulting firms, excluding non-operational factors.
• Healthy EBITDA: A benchmark EBITDA of 20%+ is desirable, with every 5% increase adding a 1.5x valuation multiple. Lower EBITDA can be offset by high growth potential, unique assets, significant investments, or temporary economic impacts.
• Importance of Growth: EBITDA growth is more critical than current levels. Firms with 20%+ EBITDA growth over three years attract higher valuations. Growing EBITDA margins indicate good management and scalability.
• Strategic Management: Sustainable profitability comes from investing in the firm’s niche, intellectual property, and personnel. Reinvesting EBITDA above 25% into growth fosters long-term value.
• Communicating Financials: Firms with sub-20% EBITDA and growth should clearly explain their financial journey and investment cycles to attract buyers.

What is EBITDA and Why is It Important?

Earning Before Tax, Depreciation, Amortisation (EBITDA) is a useful measure of net profits because it removes the firm-specific decisions that might be taken about things outside the operations of the firm – for example, non-cash expenses, the reduction in value of assets, and local decisions on tax structuring.

In most consulting firms, assets aren’t usually a significant factor in the firm, and thus EBITDA is often roughly the same as EBIT (net profit).

For buyers and investors of consulting firms, EBITDA is useful because it allows an approximate comparison of baseline profitability between different firms without getting distracted by capital expenses.

There are of course many other financial measures that are important, and EBITDA has several criticisms as a measure of financial health, but it is still the baseline for most consultancy valuations.

What Does Healthy EBITDA Look Like?

It is well known that buyers or investors like a healthy profitable company, resulting is an EBITDA of 20% or over. Typically, every additional 5% will drive another 1.5x multiple.

However, it should also be noted that ‘it depends’. In some forms of professional services (e.g. managed services or training) EBITDA is often lower and thus benchmarks for what is ‘investable’ are also lower.

Buyers will also forgive lower EBITDA if sellers can show:

• They are in a high growth niche (e.g. AI and automation consulting)
• They have rare and effective knowledge assets (e.g. methodological IP)
• They have invested significantly and effectively in growth levers
• EBITDA has been depressed for most firms due to a recession or other short-term economic event.

Despite these exceptions, buyers usually get concerned by EBITDA margins lower than 14%. I’m generalising here a little, but in a healthy consulting firm, a maximum of 50% of revenue will be spent on the delivery of services, a maximum of 30% would go on overheads, leaving a minimum of 20% for EBITDA.

EBITDA Growth is More Important Than EBITDA

It is also well known that growing profits are a sign of a healthy business. Buyers invest on the basis of future growth not past performance, but growing profits – together with a visible pipeline and long-term clients – give buyers confidence that growth will continue.

A firm with zero growth can still sell but will generally attract half the price of a firm with revenues growing at 30% a year. A minimum of 20% EDITDA growth for the previous three years is usually sufficient to drive a good price.

Double the number of buyers would reject a firm because of low growth compared to low profits and for every ten percent increase in annual EBITDA growth, the multiple goes up approximately by a factor of one.

When growth drops or even reverses during a sales negotiation, buyers often pull out or want to renegotiate. The multiples in Table 2 are averages and it should be stressed they can be as high as 18 depending on the niche and IP.

Table: EBITDA growth and valuation multiples

It is less well known that the growth in EBITDA margin (%) is also important. A growing profit margin shows that the business is achieving the economies of scale and scope which, in turn, is a sign of good management. These economies are important if a firm is likely to double or treble in size over the next five years.

Maximising EBITDA Should Not Be the Goal

Think of 25% EBITDA as the speed of a car. A car that can’t reach 80 mph is probably not a great buy – although if the buyer has specific needs, they may be able to forgive this failing.

However, a badly maintained car with a poor quality engine may be able to hit 80mph for a short period but keeping it at this speed for a while may prove difficult and ultimately will damage the car – it may even destroy it!

Three factors are important in finding a car that can consistently run at 80mph:

• A great make of car (think, a great niche!). It’s a lot easier to drive fast for a long time if you have a Mercedes S-class.
• A car that has been invested in (think, IP!). If you have paid for an additional spoiler, a turbo-charger or tyres, it’s likely that your car will go faster for longer.
• A car that uses great consumables, such as oil and fuel (think, your people!)

For owners then, it is important to consider firm as an asset. The ability to reach 80mph or 25% EBITDA is an outcome that depends on the type of car you have and how you have invested in it.

They key lesson here is that the pursuit of 80mph is something that is best achieved by attending to the quality of the asset, not simply by putting your foot down on the accelerator (putting up pricing and cutting costs!).

For this reason (though it depends on various other factors) I’m keen on owners investing a proportion of EBITDA above 25% into growing revenues.

This typically results in faster growth and a more valuable asset creating not only a bigger pie for people to share, but a higher multiple.

Your EBITDA Story

Of course, the world being what it is, it’s not uncommon to find firms that want to sell that don’t have 20+% EBITDA and 20+% EBITDA growth and margin growth, certainly not for a period of 3+ years. Firms tend to grow in S-curves reflecting both the cyclical nature of the economy and investment / growth cycles.

For these firms, it is important to craft your story so that investors or buyers are clear on why, when and how you didn’t meet these targets. When selling, your broker or back will help you do this, and it will culminate in the Investment Memorandum.