SaaS Businesses: Addback R&D to Adjusted EBITDA?

August 01, 2020

by a searcher in Los Angeles, CA, USA

In evaluating a software business, is it okay to add back research and development costs to calculate adjusted EBITDA? The thought process is that R&D will provide future revenue in the form of new features, and functionality. for the software to stay competitive...so to calculate current year free-cash-flow, R&D should be added back to earnings. Interested in commentary from folks who have financed a SaaS business.

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Reply by an investor
from University of California, Berkeley in San Francisco Bay Area, CA, USA

In my experience sellers capitalize R&D cost primarily to inflated EBITDA. There may be some cases where it is justified, for example if there is an isolated one time R&D activity that is outsourced to a 3rd party. However, in most cases product development cost is just the cost of doing business and you should include it the EBITDA calculation if the company is being valued on an EBITDA basis. That being said, if the company is a fast growing and successful SaaS business with low churn, then EBITDA doesn’t really matter and you should probably consider a revenue multiple.

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

EBITDA is a starting point in valuation, not an end. From EBITDA, you have to deduct all cash outlays. So, let us say you add R&D to EBITDA b/c it was capitalized. Now, for future cash flow, you should deduct future R&D. I R&D is not required going forward, or not at the same level, addition of R&D to EBITDA truly increases EBITDA. This is not different than CapX. Again, focus on future cash flow after you start with EBITDA.. I know SFs are highly educated, but I often find that many of them are brain-washed with valuation is just a simple multiple of EBITDA.

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