Accurate estimation of maintenance capital expenditures (CapEx) is critical in business valuations for SBA 7(a) loan purposes, particularly when using the capitalization of earnings method. While EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a common valuation proxy due to its pre-debt, pre-tax simplicity, it excludes CapEx, a recurring cash outflow. This omission can overstate a company’s cash-generating ability, inflating valuations and risking unsustainable SBA 7(a) loans. This white paper examines maintenance CapEx’s role, EBITDA’s flaws, and estimation methods, emphasizing SBA 7(a) valuation reliability.

Understanding Maintenance CapEx

Maintenance CapEx refers to expenditures required to sustain current operations, distinct from growth CapEx, which expands earnings potential. In SBA 7(a) valuations, maintenance CapEx ensures sustainable free cash flow (FCF) for debt servicing, reflecting the business’s ability to maintain assets like equipment and facilities without compromising earnings.

The Flaw in EBITDA as a Cash Flow Proxy

EBITDA ignores CapEx, leading to overstated FCF and overvalued businesses. Capital assets deteriorate and require replacement, a reality EBITDA overlooks. Valuation expert Gilbert Matthews critiques the assumption that CapEx equals depreciation, noting it’s unrealistic for most businesses, especially in inflationary or growth contexts. Matthews further argues that this assumption distorts terminal value by underestimating reinvestment needs. Depreciation is an accounting estimate, while CapEx reflects actual investment, and underinvestment erodes earnings capacity.

Estimating Maintenance CapEx

Five methods estimate maintenance CapEx:

1. Historical CapEx Analysis: Average 3–5 years of CapEx, adjusting for non-recurring items.
2. Depreciation Proxy: Use depreciation as a rough estimate, suitable for capital-intensive industries, assuming alignment with replacement needs.
3. Industry Benchmarks: Compare to norms from RMA Annual Statement Studies, First Research/Hoovers/D&B, or IBISWorld, often as a percentage of revenue.
4. Asset-Based Estimation: Assess fixed asset schedules, assigning useful lives and estimating replacement costs.
5. Management Interviews: Discuss plans to distinguish maintenance from growth CapEx.

Useful Life of Asset Classes and Impact on CapEx Assumptions

Asset useful lives, per IRS Publication 946 and GAAP, guide CapEx estimation:

• Machinery & Equipment: 7–15 years
• Vehicles: 5 years
• Furniture & Fixtures: 7 years
• Computers & Technology: 3–5 years
• Buildings: 30–40 years

Short-lived assets (e.g., technology) require frequent replacement, increasing maintenance CapEx, while long-lived assets (e.g., heavy equipment) involve larger, infrequent expenditures.

Why Ignoring CapEx Is Unrealistic

Excluding maintenance CapEx assumes a business can operate indefinitely without reinvesting in assets, unrealistic for operations with physical or service components. Asset deterioration or obsolescence leads to inefficiencies, safety issues, or service decline, eroding earnings. Buyers, lenders, and appraisers must account for CapEx to avoid overvaluation, ensuring valuations reflect economic reality.

Conclusion

In SBA 7(a) valuations using the capitalization of earnings method, omitting maintenance CapEx undermines valuation reliability. While EBITDA simplifies performance analysis, it excludes critical reinvestment needs. Estimating CapEx via historical trends, asset analysis, or industry norms ensures defensible valuations. Accurate CapEx supports sustainable SBA 7(a) loans, protecting lenders and borrowers.