In the world of business finance and mergers & acquisitions (M&A), understanding key financial metrics is essential for structuring deals, setting performance benchmarks, and evaluating profitability. One metric that is gaining more attention in these contexts is High Water EBITDA. In this blog post, we'll explore what High Water EBITDA means, its advantages and disadvantages, and why it is a critical concept in M&A and financial agreements.
What is High Water EBITDA?
High Water EBITDA refers to the highest level of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) that a company has achieved over a specific period of time. This high point, or "high water mark," serves as a benchmark for future performance evaluations. It is commonly used in financial agreements such as earnouts, incentive structures, and debt covenants.
EBITDA, itself, is a metric used to assess a company’s operating performance by stripping out non-operational expenses such as interest, taxes, depreciation, and amortization. High Water EBITDA, therefore, highlights the most profitable year or period for a company and sets a performance standard moving forward.
Why is High Water EBITDA Important?
High Water EBITDA is often used in business negotiations, particularly in M&A transactions, to align incentives between buyers and sellers. It also serves as a financial safeguard for lenders and investors by ensuring that a company maintains certain profitability levels. This metric can be particularly useful in scenarios like:
M&A Earnouts: When a seller receives additional payments based on future performance.
Debt Covenants: Where lenders require borrowers to maintain profitability above certain thresholds.
Executive Compensation: Performance bonuses and incentives for managers and key employees can be tied to reaching or surpassing High Water EBITDA levels.
In the following sections, we'll break down how High Water EBITDA works in various financial agreements and the pros and cons of using it as a performance metric.
How Does High Water EBITDA Work in M&A Transactions?
Earnouts in M&A transactions are a common area where High Water EBITDA is applied. Earnouts allow sellers to receive future payments based on the company's performance post-acquisition. These payments are often contingent upon exceeding a specific EBITDA threshold, which could be based on the company's High Water EBITDA.
Example of High Water EBITDA in M&A
Let’s say Company ABC was acquired with a provision for an earnout based on future performance. ABC had its highest EBITDA of $10 million last year. The earnout agreement might state that if ABC’s EBITDA exceeds $10 million over the next two years, the seller will receive an additional payment.
In this case, High Water EBITDA becomes a performance target that incentivizes the company to continue generating profitability post-acquisition. This aligns the interests of the buyer, who wants a well-performing business, and the seller, who stands to benefit financially if the company surpasses its high water mark.
High Water EBITDA in Debt Covenants
Debt covenants are agreements between lenders and borrowers that impose certain financial performance requirements. Lenders often use High Water EBITDA to ensure that the borrower maintains a level of profitability sufficient to cover debt payments. If a company’s EBITDA drops below its High Water Mark, penalties such as increased interest rates or restrictions on additional borrowing can be imposed.
Advantages of Using High Water EBITDA in Debt Covenants
Protection for Lenders: High Water EBITDA provides lenders with a clear, historical benchmark to gauge whether the company is maintaining its financial health.
Motivates Performance: Borrowers are incentivized to maintain or exceed the High Water Mark to avoid triggering penalties or restrictions.
Disadvantages of Using High Water EBITDA in Debt Covenants
Pressure on Borrowers: Borrowers may face undue pressure to meet unrealistic performance expectations, especially if the high water mark was achieved during unusually favorable conditions.
Risk of Penalties: Failure to meet the High Water EBITDA target could result in higher interest rates, limited borrowing options, or even early loan repayment.
Advantages of High Water EBITDA
1. Motivates Consistent Business Performance
One of the primary advantages of using High Water EBITDA is its ability to motivate management to sustain high profitability. By tying bonuses, earnouts, or other incentives to surpassing or maintaining the High Water EBITDA, companies are driven to improve operational efficiency and control costs.
2. Aligns Interests of Buyers and Sellers in M&A
High Water EBITDA ensures that both the buyer and the seller in an M&A transaction have aligned goals. The seller is incentivized to maintain high performance post-sale, while the buyer is assured that they are not overpaying for a company with declining profitability.
3. Standardized Metric for Comparison
EBITDA is widely accepted as a measure of operational performance. Using High Water EBITDA as a benchmark allows for a standardized, objective way to assess a company’s performance, making it easier for both parties to agree on terms in financial agreements.
Disadvantages of High Water EBITDA
1. Unrealistic Benchmarks Can Cause Problems
If a company achieved its High Water EBITDA during an unusually profitable period, such as a market boom, it may be difficult or even impossible to maintain that level of performance in subsequent years. Setting too high of a performance target can lead to stress and short-term decision-making that harms the company in the long run.
2. Overemphasis on EBITDA Can Lead to Financial Manipulation
Because bonuses, earnouts, or debt agreements may be tied to EBITDA, there is a risk that management might attempt to manipulate the company’s financials to inflate EBITDA artificially. This could include deferring necessary expenses or prematurely recognizing revenue to make the numbers look better on paper.
3. Ignores Other Key Financial Metrics
EBITDA, while useful, doesn’t take into account other important financial considerations such as debt servicing, cash flow, or capital expenditures. Focusing solely on High Water EBITDA can give a skewed view of a company’s overall financial health.
How to Properly Use High Water EBITDA
For businesses, investors, and lenders looking to use High Water EBITDA effectively, it’s important to:
Set Realistic Performance Benchmarks: Make sure that the high water mark is achievable in the long run and not based on a one-off, exceptional year.
Consider Other Financial Metrics: In addition to EBITDA, look at other key performance indicators such as cash flow, debt levels, and net income to get a comprehensive picture of financial health.
Communicate Expectations Clearly: In M&A transactions or debt agreements, ensure that both parties have a clear understanding of how the High Water EBITDA will be calculated and applied.
Conclusion: Is High Water EBITDA Right for Your Business?
High Water EBITDA can be an effective tool for motivating performance, aligning interests in M&A transactions, and providing financial safeguards in debt agreements. However, it must be used thoughtfully to avoid setting unrealistic expectations or encouraging financial manipulation. By considering both the advantages and disadvantages, companies can use High Water EBITDA to achieve long-term profitability while maintaining financial stability.
Whether you’re negotiating an M&A deal, structuring executive compensation, or securing financing, understanding High Water EBITDA and its implications is key to making informed, strategic decisions.
Dr. Allen Nazeri, aka "Dr. Allen," boasts over 30 years of global experience as a healthcare entrepreneur. He is the Managing Director at American Healthcare Capital and Managing Partner at PRIME exits. Dr. Allen provides strategic growth consulting to leadership teams of both privately held and publicly listed companies, ensuring their preparedness for successful exits.
He holds a Dental Degree from Creighton University and an MBA in M&A and Investment Banking from the University of Bedfordshire. Dr. Allen is the author of "Value Engineering: Strategies to 10X the Value of Your Clinic and Dominate the Market!" and the brand new book "Selling Your Healthcare Company at a Premium". Dr. Allen offers a free valuation to business owners ready for a partial or complete exit strategy. Dr. Allen collaborates with strategic buyers, private equity firms, and institutional investors, taking direct accountability for the annual successful sell-side representation of nearly $750M in enterprise value.
To have a confidential discussion about your company and receive a free valuation, please email Allen@ahcteam.com or Allen@ahcpexits.com
You can now communicate with Dr. Allen's clone https://www.delphi.ai/drallen
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