The second bridge ends with a business that no longer depends on its owner and a list of what it produced to prove it. The third bridge begins by checking that list, line for line, with a bar for each. Two things set this inspection apart from the one at the start of the second bridge. The bars are the ones a fund's diligence applies. And for much of the list, the inspectors are the professionals a fund would send: a quality-of-earnings review, counsel, an independent reviewer of the model.
The second difference carries the most weight. A business that wants to be valued on its free cash flow by a buyer who models will be inspected by that buyer's people. Inspecting it with the same kind of people first, before anything else is built on the figure, means the third bridge starts from earnings a buyer has, in effect, already accepted.
Five questions, inspected by professionals
The inspection at the start of the third bridge is the second bridge's deliverables, each with a bar, and much of it is now checked by the people a buyer will send. Select a question.
Can a fund rely on the statements?
- Lines inspected
- Three years of reviewed accrual statements with a proof of cash; returns reconciled to them
- Inspected by
- A quality-of-earnings review; the outside accountant
- A failure goes back to
- From SDE to Normalized SDE
Does it run without its owner?
- Lines inspected
- A named lead in every seat at benchmark under written agreements; the owner's absences; written procedures that ran during them
- Inspected by
- The lead, against a compensation survey and the records; counsel on the agreements
- A failure goes back to
- From Normalized SDE to Pro Forma EBITDA, or From Pro Forma EBITDA to Reported EBITDA
Are the earnings clean and the company's?
- Lines inspected
- Adjustments few and historical; related parties at market; customer concentration and retention; company contracts; the liabilities file
- Inspected by
- The quality-of-earnings review; counsel
- A failure goes back to
- From Reported EBITDA to Adjusted EBITDA, or earlier spans for related parties and contracts
Will it grow without the owner selling?
- Lines inspected
- Growth by source; retention by cohort; the pipeline's record; the price, volume and mix bridge; the sales seat against quota
- Inspected by
- The quality-of-earnings review; the lead from the pipeline system and payroll
- A failure goes back to
- From Reported EBITDA to Adjusted EBITDA
What is it worth, and did the crossing pay?
- Lines inspected
- Return on capital; competitor map; reproduction and liquidation value; base rates and scenarios; every price reversed; the holder's inputs and return; maintenance spending; reinvestment rate; the buy-sell
- Inspected by
- The lead against the valuation; an independent model reviewer on the probabilities; counsel on the agreement
- A failure goes back to
- From Reported EBITDA to Adjusted EBITDA
Who the inspectors are
Each of the three professionals examines something different. A quality-of-earnings review is an accountant's investigation of whether reported earnings are what they seem: it ties revenue to cash, tests every adjustment, and restates the earnings it cannot accept. Its purpose differs from the outside accountant's annual review, which asks whether the statements are materially right; the quality-of-earnings review asks what a buyer should pay for. Counsel reads the agreements: the employment contracts, the customer and supplier contracts and their change-of-control clauses, the buy-sell, and the searches for liens and litigation. An independent reviewer of the model checks the probabilities in the scenarios and the base rates behind them, because those numbers move the value and nobody inside the business can fairly check their own.
All three cost money, spent before any buyer has appeared. The case for spending it is the case the whole bridge rests on. A buyer will commission the same examinations, and a finding that surfaces in the buyer's examination costs far more than one that surfaces in the seller's.
Can a fund rely on the statements?
The statements must cover three years on an accrual basis, reviewed by an outside accountant (a compilation is not enough), with a proof of cash tying reported revenue to bank deposits within a narrow margin. A quality-of-earnings review inspects them, the same kind of examination a fund will commission. Three years of returns must also reconcile to the statements, every difference scheduled, and the outside accountant checks that.
These lines come first because the rest of the inspection is measured from the statements. A cohort analysis, a price bridge or a return on capital computed from statements a fund will not rely on has nothing under it.
Does it run without its owner?
Every function needs a named lead. The owner holds at most one seat, costed at market, with a named successor. Every lead is paid within range of a market benchmark and works under a written agreement with confidentiality terms and, where the law allows, terms against soliciting customers and staff. Nobody other than the owner carries a large share of revenue or delivery. Each core function has a written procedure, and the function ran on it while the owner was away; the inspector checks this by walking one procedure with the person who runs it.
The absence line is careful about what it proves. The record has to show the owner away within the latest year for long enough to matter, either more than once in different parts of the year or for one extended stretch, with no operating decision taken remotely and no dip in revenue or delivery beyond normal monthly variation. The file has to say what that shows and what it does not: the business survived the absences observed, which is short of proof that it runs without its owner indefinitely. The valuation needs a probability that the owner's successor fails, and that probability is then set from the base rate for businesses with such a record. The owner's confidence does not enter into it.
Are the earnings clean and the company's?
Adjustments to earnings, other than the owner's own pay, must be a small share of EBITDA, and each must be historical, one-off and documented; run-rate, pro forma and synergy adjustments are not counted. Every arrangement with the owner, family or related companies must be at a documented market rate under a written agreement, or unwound. No single customer may carry too large a share of revenue, no small group of the largest may approach half of it, and customers who produced the great majority of last year's revenue must still be buying. Every material customer and supplier must be under an assignable contract with the company, with change-of-control clauses flagged. And the liabilities file, covering searches, tax filings, contractor classification and licences, must be clean or disclosed.
The quality-of-earnings review and counsel inspect most of these lines, since a fund's own review and its lawyers will test them hardest.
Will it grow without the owner selling?
Three years of growth must be split between existing customers and new, and in the latest year new-customer growth must at least match the revenue lost to churn. The pipeline lives in a system the sales lead runs, with the owner named on only a small share of its value. Each of the last two annual groups of customers must have kept most of its prior-year spending, net of churn and expansion.
The pipeline itself needs two years of win rate and cycle length by quarter with no material decline, and enough value at each quarter's end to cover the next quarter's target several times over. A price, volume and mix bridge must cover three years and reconcile to the statements. And the sales seat needs a written quota and plan approved before the year began, with a year of results at or near quota and little of the closed revenue attributed to the owner.
Passes, or a finding?
Illustrative. The bars at this checkpoint are a buyer's diligence bars. Guess which of these an inspector would accept, then select each to see why.
Select each item to see the verdict.
The bar is an absence long enough to matter, more than once in different parts of the year or for one extended stretch. One fortnight starts the record; it does not make one.
An operating decision taken remotely means the business did not run without the owner, whatever the figures say.
Both kept most of their prior-year spending, from the sales ledger, so the base is growing.
The bar is two years by quarter, so the latest four quarters can be compared with the four before.
Material suppliers need assignable company contracts as much as customers do.
The statements a fund relies on, with the proof of cash its reviewers run first.
What is it worth, and did the crossing pay?
The last group checks the inputs to the valuation. The return on invested capital must cover three years on the definition fixed at the first anchor and carried unchanged, never computed on a figure before depreciation, split into margin and turnover and compared with the cost of capital, with three years acknowledged as the short sample it is. The competitor map must name every competitor in each market with three years of share, and show a barrier in one of three ways: customers who stay and would bear a cost to switch, a cost advantage visible in gross margin, or local scale. The reproduction-value schedule now includes the cost of writing and installing the procedures and systems. Base rates and scenarios must place every forecast against named benchmark series, with each record's sample size stated, and an independent reviewer of the model checks the probabilities. The price reversal log must show that no input changed after a price was seen without a recorded reason. And the file must hold the holder's inputs, the estimates of maintenance spending and reinvestment, the buy-sell analysis wherever there are co-owners, and the value of an orderly sale of the assets.
One line asks something no earlier checkpoint could: did the last crossing pay the owner? The holder's return compares the distributions the owner has received since the valuation at SDE, plus the change in value between that valuation and this one, with the return the owner required over the same period. Both values come from the business's own files, so the comparison is like for like.
Did the crossing pay the owner?
Illustrative. The holder's return over a crossing: what the owner received in distributions since the last anchor's valuation, plus the change in value between that valuation and this one, as a share of the value at the start, set against the return the owner required over the same period. Both values come from the business's own valuation files.
Crossing the second bridge costs money every year, in payroll, reviewed statements and a management team, and the owner is entitled to know whether that cost was repaid. In the illustration, an owner whose business was valued at $1.5 million at SDE and at $2.4 million now, with $250,000 received in between, earned about 77 percent over the period against a requirement of 64 percent, which is about $190,000 of value created. The result could as easily be negative, and the inspection then records value destroyed, so the owner does not judge the crossing by the asking price alone.
Where a failure goes, and how a business slips
A business that fails a line goes back to the first span of the second bridge whose measure it cannot show. The routing works as it did at the previous checkpoint: the first failure names the work, and the order of the spans ensures nothing is repaired before what it depends on.
Most of the ways a business slips off adjusted EBITDA are the second bridge coming undone: the owner drifting back into a seat, a manager not replaced, a large account drifting back to the owner's phone, personal spending returning, adjustments multiplying, the statements slipping back to a cash basis, one customer growing until it is the business, a filing lapsing, the owner selling again, prices cut to hold volume, the sales lead leaving with the quota. Two are new. The competitor map and the base-rate file go stale, and the scenarios drift back toward one optimistic case. And the record of distributions is never kept, so that a minority interest in the business, if one is ever valued for a gift, an estate or a co-owner's departure, has nothing to be priced on. Each leaves the business looking the same and worth less, which is why the inspection reads for all of them.