EBITDA in Software

EBITDA is how software companies get priced. It’s also where the gaps between accounting and cash reality hide.

The formula

EBITDA = Earnings before interest, tax, depreciation, and amortisation

In software, the logic goes: strip out financing decisions (interest), tax jurisdiction effects, and non-cash charges (D&A) to reveal underlying operating profit. It’s the standard basis for valuation multiples and the number PE buyers anchor on.

The appeal is comparability. Different capital structures, different accounting policies, different geographies — EBITDA normalises across all of them. That’s the theory.

What it measures

EBITDA captures operating profit before capital structure and accounting choices. For a mature, steady-state software business with minimal capex, it approximates cash generation reasonably well.

The metric dominates software M&A because it’s the common language. Buyers price on EV/EBITDA multiples. Sellers optimise toward it. Debt covenants reference it. Everyone speaks EBITDA.

For businesses with stable revenue, modest growth investment, and straightforward cost structures, EBITDA tells you roughly what the business earns before you decide how to finance and tax it.

What it hides

Software EBITDA hides more than most.

Capitalised development is still cash. Software companies capitalise development costs as an intangible asset, then amortise over several years. This shifts spend from operating expense to the balance sheet — EBITDA rises, but cash went out the door. A company capitalising £2m of development annually shows £2m higher EBITDA than one expensing the same spend. Same cash, different profit.

The corollary: watch for drift. A company shifting from capitalised to expensed development — or vice versa — will show EBITDA movement that has nothing to do with underlying performance. The accounting changed; the business didn’t.

Sales investment hits immediately, revenue arrives later. When you spend £100k acquiring a customer who’ll pay £50k annually for four years, the full £100k hits this year’s income statement. The £200k of revenue arrives over four years. EBITDA looks worse in the investment year, better in the harvest years.

For high-growth software investing heavily in customer acquisition, EBITDA understates the value being created. For software cutting sales spend to inflate near-term profit, EBITDA overstates sustainable earnings. The timing mismatch is structural.

Adjusted EBITDA adjusts a lot. Software “adjusted EBITDA” can exclude restructuring, acquisition costs, integration expenses, and increasingly creative items. The gap between GAAP operating profit and adjusted EBITDA sometimes exceeds 20 points. Check what’s being adjusted and whether it recurs.

Where it breaks down

High-growth businesses. A software company growing 40% annually while investing heavily in sales, marketing, and R&D will show depressed EBITDA. That’s not weak profitability — it’s investment. Judging a growth company on current EBITDA misses the point.

Acquisition-heavy models. Serial acquirers generate significant D&A from acquired intangibles. EBITDA adds this back, making the business look more profitable than the cash it generates. For acquisition-driven software companies, cash flow tells a truer story.

Different capitalisation policies. Two software companies with identical economics can show different EBITDA depending on capitalisation thresholds and useful life assumptions. Cross-company comparison requires understanding the accounting, not just the number.

Working capital effects. Software with annual upfront billing has favourable working capital — deferred revenue funds operations. Software billing monthly or in arrears needs working capital to fund the gap. EBITDA doesn’t distinguish; cash conversion does.

The decision it enables

EBITDA is the starting point for software valuation, not the ending point.

Bridge to cash. Start with EBITDA, subtract capitalised development (the cash already went out). For software with annual upfront billing, working capital typically adds to cash — deferred revenue means customers fund your operations. For software billing in arrears, working capital consumes cash as you grow.

Normalise for growth phase. High-growth software deserves EBITDA adjustment for customer acquisition investment. If sales and marketing is 40% of revenue and payback is 18 months, current EBITDA reflects investment that will generate returns for years. Steady-state EBITDA at mature growth rates would look very different.

Watch the adjustments. When adjusted EBITDA diverges significantly from GAAP operating profit, understand why. Some adjustments are legitimate one-offs. Others are recurring costs being systematically excluded. The pattern matters more than any single period.

Compare like with like. EBITDA comparisons across software companies only work if capitalisation policies and growth rates are similar. A 30% EBITDA margin with heavy capitalisation isn’t the same as 30% without.

EBITDA is how software gets priced. Understanding what it hides is how you avoid overpaying.

The metric series: Part of a series on metrics that reveal what headline numbers hide.

Connects to Library: How Finance Works — Cash matters more than profits; the future matters more than the present.