Inspecting SDE

The first bridge ends with a promise, in the form of a list of what the crossing produced: the books and returns, the customer records, the evidence of growth, the inputs to a valuation. The second bridge begins by checking that the promise was kept. Its entry inspection is the same list, line for line, with a bar for each line and a named person responsible for checking it. One bridge's exit says what to produce, and the next bridge's entry says how strictly it will be looked at.

The inspection is where a business's SDE stops being something its owner says and becomes something an outsider has tested. Every line on it is there because a buyer at the next anchor will test the same thing, usually less kindly.

Is the number real?

The first group of lines asks whether the earnings exist as reported. The books have to cover twelve consecutive months on one accounting basis, each month closed promptly and reconciled to the bank with no unexplained differences, and reported revenue has to tie to bank deposits month by month within a small margin. The last two years of tax returns have to have been filed on time and reconcile to the profit and loss, with every difference scheduled. And there have to be two years of monthly revenue history, drawn from the deposits and the returns, in which the latest year is not materially below the one before unless a documented one-off cause explains it.

Who inspects matters as much as what is inspected. The lead checks the books with the bookkeeper, and an outside accountant tests three months the lead picks. If the business could choose the months, the test would cover only what the business wanted to show. The revenue history comes from the bank statements and not from the business's own reports, because the bank is the one party with no interest in the answer.

Does the business carry itself?

The second group asks whether the business supports itself and its owner. Gross margin is computed for every significant line with direct costs fully allocated, and every such line has to be positive over the year, with the business as a whole positive in nearly every month. The year has to have been run at or above breakeven without new equity, owner loans or new borrowing to fund operations. The owner's draw has to have come from operating cash at a set amount in nearly every month, kept apart from business expenses, and operating profit before owner pay has to cover the draws with a cushion. Finally, the owner's pay has to take the form the entity's tax status requires, confirmed in writing by the outside accountant, with a market salary for the owner's seat documented from two named sources.

The inspector checks all of this from records the business did not prepare for the occasion: the ledger, the bank statements, the equity and loan accounts, the payroll filings. The same preference runs through the whole inspection. Wherever it can, it relies on evidence that existed before anyone knew there would be an inspection.

Are the earnings the business's own?

The third group asks whether the earnings belong to the business or to its circumstances. Every add-back, whatever its size, is tied to a ledger entry with a source document; the inspector re-performs the larger ones and samples the rest, and add-backs other than the owner's own pay have to stay within a modest share of SDE. The outside accountant walks the schedule as the external check. A broker's opinion of value is sought only after the valuation exists, and is logged as a price to be reversed. The customer list gives each customer's share of revenue, and the largest has to be below a large share or under a disclosed written contract. The compliance file shows the company in good standing, its licences current, its tax filings current with no open notices, and a lien search that is clean or has every lien disclosed.

A buyer can lose what they paid for in three direct ways: the earnings were never really there, they walk out with one customer, or something outside the books takes them away. The add-back schedule, the customer list and the compliance file answer those three in that order.

Will they grow?

The fourth group asks for evidence of growth, and it is strict about what counts. The growth record shows revenue rising with gross margin by line held or improved, and the source of every new customer, with most of them arriving through channels other than the owner. The repeat-purchase record shows most of the latest year's revenue coming from customers who also bought the year before, or, where the product is bought once, a meaningful share of new customers arriving by referral. The pricing record shows a price increase on every significant line in the last two years, with volume afterward down by no more than the increase and discounts no deeper than before. The capacity record covers twelve months of use of whichever resource runs out first, and shows room for meaningfully more work than the best month without a new hire or a new fixed cost.

The pricing line carries an idea found all through the inspection. A business that raised prices once and kept its volume has shown that the process can work, and has not yet shown that it will keep working. One observation is a small sample and the inspection treats it as one. Evidence is weighted by how much of it there is, so a single held increase moves the estimate only a little away from what businesses of this size usually achieve, while many held increases move it a long way.

What are they worth?

The last group checks the inputs to the valuation. It is the longest, because a valuation is only as honest as the numbers it uses.

Return on capital has to be shown for every closed month in the record, on one fixed definition of the capital base, split into margin and turnover and set against the cost of capital. The record is short and is labelled as the sample it is, with no claim of persistence drawn from it. The competitor map names every rival in each market with shares for every year the record covers, carries a recent as-of date, and records competitors entering and leaving. Any barrier it claims has to rest on customers who would find it costly to leave, backed by pricing power. Size alone does not count.

The reproduction-value schedule prices what it would cost to rebuild the business, item by item with a source for each, and puts the value of an orderly sale of the assets beside it. The base rates set every forecast against the growth and survival record of businesses this size from a named source. The scenarios run from the base case through the failure of the owner's successor, the loss of the largest customer and a cost shock, and, wherever there is more than one owner, each co-owner's death, disability, divorce or departure. The price reversal log takes every opinion, listing price and offer the business has met and reverses it into what it assumes, and no valuation input changes after a price has been seen unless the reason is written down.

The remaining lines fill in the holder's side. They cover the holder's own position, from the expected holding period to the cash the holder takes out; the spending needed to keep the assets working; the rate at which the business reinvests; the written definition of the capital base, unchanged since the last checkpoint or changed with a reason; the holder's return for each closed year, computed so the inspector can redo it; and, where there are co-owners, the ownership agreement read against a checklist of triggers, pricing, level of value, appraisers and funding. Anything missing, or anything the inspector cannot recompute, is recorded as a finding.

Where a failure goes

A business that fails is told where to go: back to the first span of the first bridge whose measure it cannot show. Without positive margins by line, or without the records of repeat purchases, price rises and capacity, it goes back to the span from revenue to gross profit. If it needed new capital during the year, it goes back to the span that reaches breakeven. If the owner's draw is not covered, or not in lawful form, it returns to the span that reaches the owner's draw. Shortfalls in the books, add-backs, customer list, compliance or valuation inputs send it to the last span before SDE. And a business that cannot show a single paying customer from outside its founder's circle goes back to the very start.

Because of the routing, a failed inspection tells the business what to do next. The first line it fails names the work, and because the spans run in order of dependence, it is never asked to repair something that rests on a measure it has not yet earned.

How a business slips off SDE

The inspection also lists the ways a business that reached SDE can lose it. Most are the decay the first bridge guarded against: personal spending creeping back, profit sliding toward breakeven, owner pay drifting out of its lawful form, the books falling behind, a large customer or the owner's relationships carrying the revenue, prices lagging costs, the business needing new capital, filings lapsing, returning customers no longer returning, a price rise given back in discounts, and growth stalling on a constraint nobody measured.

Six are new. They concern the valuation more than the operations, which makes them harder to notice. The competitor map goes stale as the owner stops asking who else bid for the work. The base rates are not refreshed, and the scenarios drift back toward a single optimistic case. The capital base is redefined to flatter the return. The estimate of maintenance spending is never revisited as the assets age. The holder's return is never computed, and the crossing is judged on the asking price alone. A co-owner leaves with no agreement in force. In each case the business looks the same and is worth less, so the inspection reads for these as carefully as for the rest.