From Reported EBITDA to Adjusted EBITDA

By this point on the second bridge the business has done the hard part. The owner's seats are filled, the business has run without its owner, and the customers deal with the company. What remains is to make sure all of that survives the most searching examination it will ever receive: a buyer's quality-of-earnings review and legal diligence, run by professionals whose job is to find every reason the price should be lower. The last span is a rehearsal for that examination, held early enough that anything it finds can still be fixed.

What the measure is

The measure this span reaches is adjusted EBITDA, which is also the anchor at the end of the bridge: earnings before interest, taxes, depreciation and amortization, with the owner paid at market rate and only defensible one-off items added back. What it is worth, and to whom, is the subject of the essay on the exit anchor.

Adjusted EBITDA differs from reported EBITDA by its adjustments, and the gap between the two is what this span works on. A buyer who will not run the business pays a multiple of adjusted EBITDA, so every adjustment raises the price by the multiple, and every adjustment the buyer's team strikes lowers it by the same amount. The work here is to make the gap small and every item in it unarguable, and to show that the earnings it describes are durable enough to grow.

The four drivers

Add-back Tightening cuts the adjustments down to the ones a reviewer will accept. Anything that keeps recurring goes back into the expenses, anything that depends on the future comes off the schedule, and the outside accountant signs what is left each year.

Diligence Readiness prepares the two files a buyer's lawyers and accountants open first. One is the customer schedule, showing how concentrated the revenue is and whether last year's customers are still buying. The other is the liabilities file, which shows that nothing outside the statements, whether a lien, a lawsuit, a tax notice, a misclassified contractor or a lapsed licence, can reach the earnings.

Sales Engine is about growth. A buyer assumes an owner-run business stops growing when the owner leaves, and the driver builds the record that would change that assumption: revenue by when customers first bought, retention by cohort, a pipeline with a recorded conversion rate, a split of growth into price and volume, and a sales seat that has met its quota with little help from the owner.

Value Case gathers the inputs the valuation at this anchor uses, on the definitions the first bridge fixed: the return on capital record, the competitor map and the evidence of a barrier, the cost to reproduce the business and the value of an orderly sale of its assets, the risk scenarios and their probabilities, the estimates of maintenance spending and reinvestment, the holder's inputs and the co-owner analysis, and the record of every price reversed. Its work is set out in the essay on what adjusted EBITDA is worth.

Doing the buyer's work first

Every driver on this span corresponds to a part of diligence. Add-back Tightening is the quality-of-earnings team's adjustment schedule, done by the seller. Diligence Readiness is the first request list, answered before it is sent. Sales Engine is the buyer's analysis of growth, already reconciled to the ledger.

The reason to do the work early is that diligence findings are cheapest to fix before a sale and most expensive during one. A recurring cost found in the adjustments before a sale is reclassified, and the owner quotes a slightly smaller number from the start. Found by a buyer's team after a price has been agreed, the same cost lowers the price by the multiple, at the point where the seller has the least leverage. A misclassified contractor found by the seller's counsel is converted and the exposure settled. Found by the buyer's lawyers, the same contractor becomes an indemnity sized at the buyer's estimate.

How the drivers depend on what came before

The span comes last because each of its drivers tightens something an earlier span built.

Add-back Tightening works on the schedule of adjustments Separation built from the ledger. It needs the owner's retained seat on the payroll at market, from Management Install, so that the owner's pay is settled first and cannot hide other items inside it. And it needs three years closed on the same basis, which only Books provides, because recurrence can only be tested across comparable years.

Diligence Readiness draws its customer schedule from the reviewed statements under Books, so the concentration line rests on closed accounts. Its retention evidence is stronger, and its liabilities file shorter, once the material contracts are in the company's name under Relationship Transfer.

Sales Engine leans on more of the bridge than any other driver. Its cohort analysis is a view of the customer schedule Diligence Readiness builds. Retention by cohort can only be managed by account leads who own the accounts, which Relationship Transfer produced. The price and volume split needs unit price and quantity on every invoice line, which Books has to have set up. And the quota assumes a sales lead in the seat and a pipeline system paid for before the first quarter is measured. Without those, each of its numbers is a reconstruction, and a quality-of-earnings team treats reconstructions as estimates.

What the work is worth

The four drivers do quite different things to value. Add-back Tightening usually lowers the honest figure, since recurring costs return to the expenses and forward-looking items disappear, so the earnings power the valuation sees is smaller afterwards. What the seller gains is a figure that survives diligence, which the framework records as price: adjustments that would have been struck at the multiple are no longer there to strike.

Diligence Readiness moves value through two scenarios. The probability and size of the largest customer leaving fall as concentration falls, and the risk of a liability surfacing is removed when the liability is found and cleared first. Sales Engine is the only driver on the whole bridge that can add growth value, and only once the business has shown it earns more than its cost of capital on what it reinvests. Until then its value is zero; once the gate is passed it moves up the ranking.

How the span comes undone

The span decays in the ways its drivers predict. Add-backs multiply, one plausible one-off at a time, until a buyer stops believing the schedule. One account grows until it is the business. A filing lapses or a claim goes unrecorded. The owner starts selling again and the pipeline empties, prices are cut to hold volume and the cuts hide inside the revenue growth, or the sales lead leaves and the quota leaves too.

The driver essays set out the safeguards. Most of them come down to closing each record on a calendar, so that nothing waits for a sale to be examined. The adjustment schedule is closed and signed with each fiscal year, and the recurrence test reruns across a rolling three. The customer schedule is refreshed quarterly with an alarm set below the concentration bar, and a compliance calendar owned by the finance seat carries every filing, renewal and expiry, with the searches rerun every year. On the sales side, the owner's part in each deal is recorded at the close, price exceptions are reviewed with the annual price bridge, and the quota and compensation plan belong to the seat, so a replacement starts with a plan.

Crossing the span, and the bridge

The span is crossed when the adjustments are few, one-off and documented and would survive a quality-of-earnings review, when the customer book and the liabilities file would survive legal diligence, and when the sales engine's record of retention, pipeline and pricing would satisfy the same review that the earnings can grow without the owner selling.

That completes the second bridge. The business that entered on one owner's earnings leaves on earnings that belong to the company, paid for at market in every seat and examined in advance by everyone a buyer will send. For many businesses of this size that is the place to stop, because the buyers they will face price from adjusted EBITDA. For the rest, the next bridge asks how much cash the business produces once it has paid for the assets and the working capital its earnings require.