The Bridge from SDE to Adjusted EBITDA

A business at the start of this bridge is priced on seller's discretionary earnings: one owner's earnings, including the owner's own pay, bought by someone who means to run the business personally and accepts that it depends on whoever runs it. At the end it is priced on adjusted EBITDA, earnings before interest, taxes, depreciation and amortization, after a market-rate cost for every seat including the owner's, with the adjustments cut down to a short list of documented one-off items. SDE tells a buyer what an owner-operator can take home. Adjusted EBITDA tells them what the business earns when nobody in it is indispensable.

That change of question changes almost everything about the work. On the first bridge the business proved its earnings existed. On this one it proves they do not depend on the person who built it, and the proof moves from the owner's word to things an outsider can check: statements an outside accountant has reviewed, an organization chart with a name in every seat, an absence the business came through, and contracts in the company's name.

A different buyer

The buyer changes with the question. At SDE the buyer is an owner-operator. At adjusted EBITDA the buyer will not run the business: a search fund, a family office, a private equity firm, or a strategic acquirer with businesses of its own. Each brings a diligence team that tests every line the business presents, and each refuses to pay for earnings that depend on the owner's presence, decisions or relationships.

This buyer is also partly diversified. The owner-operator's livelihood rides on one business. A fund or a strategic holds other investments, so the risks peculiar to this business matter less to it. Its required return is lower, the same cash flow is worth more to it, and the multiple it pays is higher. That rise in the multiple is the largest effect on price anywhere on the bridge, and the framework counts it as price and keeps it out of value, for reasons that come later.

The starting point: inspecting SDE

The bridge opens by inspecting what the first bridge promised to deliver. The books and returns, the revenue history and the margin by line, the year funded without new capital, the owner's draw and how it is paid, the add-backs, the customer list, the compliance file, the records of repeat purchases, price rises and spare capacity, and the inputs the valuation used are each held to a bar. A business that misses one goes back to the span of the first bridge that produces it, and one that cannot show a paying customer from outside the founder's circle goes back to the very beginning.

The inspection also watches for a business slipping off SDE after reaching it: personal spending creeping back, profit sliding toward breakeven, the books falling behind, or a large customer or the owner's relationships carrying the revenue again. A business that has slipped is valued at the highest anchor it can still defend.

Four spans

The first span runs from SDE to normalized SDE, the same figure with every adjustment defensible and tied to the ledger. Books puts the business on accrual statements that an outside accountant reviews and that agree with the returns and the bank. Separation takes personal spending and off-market dealings with related parties out of the business, so that what remains on the schedule of adjustments is a set of lines a broker can defend one by one. The span is crossed when a broker could defend the number line by line and personal spending no longer runs through the business.

The second span runs to pro forma EBITDA, normalized SDE less a costed, market-rate replacement for the owner, who is still in the seat. Role Costing names each seat the owner occupies and deducts a benchmarked, fully loaded market cost for it. Procedure Capture writes each of those seats down as a job a market-rate hire could do, and that is what entitles the model to use the benchmarked salary. The span is crossed when a buyer can deduct a manager's salary in the model and still like the result.

The third span runs to reported EBITDA, where the replacement is hired and the cost is real. Management Install fills every owner seat on the staffing plan, by hiring or promotion, at the benchmarked cost, so the deduction moves from the model to the payroll. Absence Test proves the number is earned without the owner, through a planned absence of meaningful length in which the business runs on its leads and its written procedures and the period's figures are recorded. Relationship Transfer moves the revenue and supply relationships from the owner to the company, with contracts in the company's name and a lead as the working contact. The span is crossed when management is in place and the owner has been away for a meaningful period without a dip.

The fourth span closes the gap between reported and adjusted EBITDA. Add-back Tightening shrinks it to a short list of documented one-off items that a quality-of-earnings team accepts without a haircut. Diligence Readiness assembles the customer evidence and the liabilities file, which tell a buyer whether last year's earnings are still there and whether anything can take them away. Sales Engine produces the evidence a buyer uses to test growth: who buys again and for how much more, how the pipeline converts, whether growth was bought with price, and whether anyone but the owner can sell. Value Case produces the inputs the valuation at this anchor uses. The span is crossed when the remaining adjustments are few and would survive review, the customer book and the liabilities file would survive legal diligence, and the sales engine would stand up to the same review as evidence that the earnings can grow without the owner selling.

What the work is worth

The framework values every piece of work on this bridge with the three tools it used on the first: a change in the cash flow, capitalized at the cost of capital; a change in growth that passes the franchise gate; and a change in the probability or size of a named scenario, multiplied by the value at risk in it. Nothing is valued by multiplying earnings by a sale multiple.

Here the third tool does most of the work. The largest risks a buyer prices at this anchor are that the owner's successor fails in the first year and that the biggest customers leave with the seller. Both are scenarios in the valuation, each with a probability. The drivers that move most value on this bridge are the ones that lower those probabilities by changing the business itself. Changing only the evidence about the business does not count.

The cash flow mostly moves the wrong way. Pricing the owner's seats at market, hiring people to fill them, and taking out recurring costs that had been disguised as one-off adjustments all lower the honest earnings figure. The framework calls these corrections. They have to be made, because a buyer's model would make them anyway, and a business that makes them first shows a figure the buyer's model will confirm. None of them creates value.

The framework is just as strict about what does not count as value at all. The multiple rising from an owner-operator's level to a fund's, a holdback released because the business has shown it can run without its owner, the haircut dropped because the statements were reviewed, a probability that fell only because the evidence improved: each raises the price, and none changes the cash flow or its real risks. They are kept in a separate column, worked out as consequences of the value drivers, and never used to rank the work.

So Books and Separation carry no rank. Everything they do on this bridge changes what a buyer can verify. They are still done first, because nearly every ranked driver depends on them, and the work is sequenced by its preconditions while the ranking records where the value lies.

The order of the work

The ranking rule is value moved per unit of effort and capital. For a typical business at this bridge it puts three drivers at the top for one shared reason: each lowers the probability of the two scenarios that carry most of the value at risk, and does it by changing the business.

Relationship Transfer comes first. Moving material accounts from the owner to the company, under contracts in the company's name and with a contact who is not the owner, is the cheapest work on the bridge measured against its largest exposure.

In the illustration, $600,000 of yearly revenue in accounts the owner manages personally carries an after-tax margin of $112,500. If moving those accounts to the company cuts the chance they leave with the seller from 40 percent to 10 percent, the expected yearly loss avoided is $33,750. At an illustrative 14 percent cost of capital for a fund or strategic buyer, the transfer adds about $241,000 of value, for work that is mostly contracts and introductions.

Management Install is second. Making nobody indispensable lowers the probability that the successor fails, and that any one person's departure takes a large share of revenue with them, but it costs real payroll, which keeps it below the cheaper work of moving relationships. Procedure Capture is third: it makes the owner's seats learnable for the price of a writer's time.

Diligence Readiness and Sales Engine follow. Sales Engine is worth nothing until the franchise gate is passed. Once it is, it becomes the only driver on the bridge that adds growth value, and it moves up. The Absence Test ranks lower than its prominence suggests, because only the gaps it exposes and the fixes that follow count as value. Surviving the absence is evidence, and evidence belongs in the price column. Add-back Tightening and Value Case come later. Role Costing comes last, since its effect is a correction that lowers the honest value, however necessary it is.

The capital-structure lever does not come up on this bridge. The portfolio lever does, through buying or selling a product line, and it is tested like any other reinvestment, at its own return. An acquisition before the gate is passed has nothing to be tested against, so it ranks after the operating work unless a line is plainly earning below its cost of capital.

The ranking sets the incentives too. Each ranked driver's progress metrics become the incentive metrics of the seat that owns it, with a target and a payout curve. The sales lead is paid for material accounts moved to a contact who is not the owner, the operations lead for procedures that pass a dry run without the owner, and the finance lead for a liabilities file with nothing left open. Payouts come only from value the business has earned in the period, and no payout is tied to an effect on price. The owner's own scorecard tracks the customer contacts they still handle each week and their share of closed revenue. Both should fall, and neither carries a payout, because the owner is paid in value.

The destination: adjusted EBITDA

Adjusted EBITDA is earnings before interest, taxes, depreciation and amortization, with the owner paid at market and only defensible one-off items added back. It is defined for a buyer who will not run the business and wants to know what it earns when every seat costs what the market charges.

The underwriter here will not pay for anything that depends on the owner. Because it is partly diversified, its required return is lower than an owner-operator's and it pays a higher multiple on the same cash flow, which is the reward for crossing. The essay on what adjusted EBITDA is worth sets out how the valuation at this anchor turns the earnings into a value a fund can underwrite. The deliverables are the list the next bridge inspects on its first day, and they follow the four spans: reviewed accrual statements and a clean separation of personal spending; every owner seat costed and written down as procedure; a filled organization chart, an absence log and contracts in the company's name; a tight schedule of adjustments, a liabilities file, the customer evidence and the sales-engine record; and the inputs the valuation consumed.

The arithmetic of crossing

The owner sees the cost of crossing every month, in the payroll for the people now in the owner's seats. That cost lowers the earnings the business is priced on, and the crossing pays only if the higher multiple a fund or strategic buyer applies more than makes up for it. It is worth doing the sum before the first hire, with the multiples labelled as what they are, which is prices other people paid.

Take a business with $400,000 of SDE. At an illustrative two and a half times SDE, a price an owner-operator might pay, it sells for about $1.0 million. Cross the bridge and hire a general manager at a market cost of $150,000, and adjusted EBITDA is $250,000. A buyer who will not run the business now has to pay more than four times that figure just to match the owner-operator's price. At an illustrative five times, the business sells for $1.25 million and the crossing has added a quarter of a million dollars to the price. At three and a half times, it has cost the owner money and a year of work.

The framework does not count any of this as value or rank the work by it. It is the question of who the buyers are, put into numbers, and it is the reason the destination is chosen before the first bridge is crossed. A business whose realistic buyers are owner-operators, at a size where funds do not look, gains nothing by making itself attractive to a fund. The relationship transfers, the procedures and the management team still reduce real risks and make the business worth more to whoever owns it, which is why they are ranked. Whether to finish the crossing and build everything a fund's diligence will ask for depends on whether a fund will be at the table.

Who stops here

Many businesses with a market of funds and strategic buyers should stop at adjusted EBITDA. It is the anchor from which those buyers usually price a business of this size. The next bridge is worth crossing only when the buyers the business will face model its cash flows instead of applying a multiple to earnings, which usually means a larger business or a longer sale process. A business that crosses it without such buyers in view will have built a forecast, a capital spending history and a working-capital discipline that its buyer was never going to pay for.