At the end of the second bridge, a business has earnings that belong to the company. Every seat is paid at market, the owner's included, the adjustments are few and documented, the customers deal with the company, and the business has run without its owner. The figure that summarizes all of that is adjusted EBITDA: earnings before interest, taxes, depreciation and amortization, with the owner paid at the market rate and only defensible one-off items added back. It is the figure a fund or a strategic buyer will be quoted. What it is worth depends on what that buyer has to believe, how much risk the buyer carries, and whether the business can grow.
What the buyer has to believe
A buyer at this anchor is asked to believe that the business earns its adjusted EBITDA after paying every seat at market, and will keep earning it under a new owner because nobody indispensable is in it and its customers buy from the company. The framework tests that claim at three strengths, as it does at every anchor, and here each test sets a specific number in the valuation.
That the earnings exist is shown by the reviewed statements, the reconciliation to the tax returns and the documented adjustments, and this sets the base-case cash flow. That they survive the owner's removal is shown by the management team, the owner's absence and the written procedures, and this sets the probability that the owner's successor fails. The absence is read narrowly, as survival of the one or two absences observed. It is never taken as proof that the business can run without its owner indefinitely. That the earnings persist is shown by the customer schedule, the contracts and the record of growth by source. This sets the probability that the largest customer leaves, and where the evidence is thin it limits how long any advantage is assumed to last.
Laid out this way, the valuation can be argued with. A buyer who disagrees with the number can see which test they disagree with, and which probability or cash flow would change if they were right.
Whose value
The standard is fair market value, the price between a hypothetical willing buyer and seller, which is how the funds and strategic buyers at this anchor price. Beside it sits investment value to a particular strategic buyer, where one exists. A competitor that can combine the business with its own may pay more, and the synergies that explain the difference are listed and attributed to that buyer, not to the business. Where the number is headed to a court, a dispute between shareholders, a divorce or a buy-sell dispute, the legal standard of the jurisdiction governs, and it decides whether any discount for illiquidity may be applied.
The business is valued as a going concern, and the alternative is computed instead of being assumed away. The value of an orderly sale of the assets, at the pace a realistic sale would take, is built asset by asset, less the costs of selling and of winding down, including severance and lease exits. One detail of that calculation matters at this anchor: the intangibles that do not survive a wind-down, the trained workforce, the procedures and most of the customer base, are carried at zero. The business's most valuable assets exist only while it operates. A business that loses its owner's relationships can decline, and the file carries both figures so that a decline can be read against the floor.
From earnings to cash
Adjusted EBITDA is an earnings measure, and it is converted to a cash flow before anything is valued. Depreciation comes out to give earnings before interest and taxes, and cash tax comes out at the rate the business pays to give after-tax operating profit, the same figure the return on capital uses. Depreciation then goes back in, and the spending that keeps the assets working comes out. For a growing business, the capital spending and working capital that growth requires come out as well, so that the cash flow pays for the growth it is credited with. What remains is the cash the business produces for everyone with capital in it.
From adjusted EBITDA to a cash flow
Illustrative. Adjusted EBITDA is an earnings measure, not cash. Depreciation and tax come out to give after-tax operating profit; depreciation goes back in and the spending that keeps the assets working comes out, giving the cash a business with no growth produces. Capitalized at the buyer's cost of capital, that is its earnings power value.
In the illustration, $870,000 of adjusted EBITDA becomes $597,500 a year of cash flow with no growth, which a fund requiring 14 percent values at about $4.27 million.
The EBITDA multiples that brokers and buyers quote are kept, and labelled for what they are: prices paid for comparable businesses. They are evidence about the market. They enter the valuation only after translation, as the return those prices imply, applied to this business's own cash flow, and a raw multiple never sets the value.
Why the same cash flow is worth more
The buyer at this anchor is partly diversified. A fund holds other investments, a strategic buyer has other earnings, and a search investor's backers have spread their money across several businesses. A diversified buyer is exposed only to the risks that do not average out across its holdings, so it demands less return for bearing one business's particular risks, and a lower required return makes the same cash flow worth more.
The same cash flow, three buyers
Illustrative. The $597,500 of no-growth cash flow above, capitalized at the return each kind of buyer requires. An owner-operator carries all the business's risk personally; a search investor's backers are partly diversified; a fund or a strategic buyer holds many other assets.
Earnings power value, millions of dollars
Nothing about the business differs between the three bars. The value rises because each buyer is less exposed to the risks specific to this one business, and so demands less return for bearing them.
Show the numbers
| Buyer | Earnings power value, millions of dollars |
|---|---|
| Owner-operator, 20% | $2.99M |
| Search investor, 17% | $3.51M |
| Fund or strategic, 14% | $4.27M |
How far the required return falls depends on who the buyers are. For a fund or a strategic buyer, the market's measure of the sector's risk stands as it is. For a search investor or a family office whose wealth is concentrated, the return reflects more of the business's own risk. Where the buyer pool is mixed, the two are weighted by the share of the pool each represents. The return also moves over time. Where a business is expected to keep crossing bridges, the part of the return that reflects concentrated holders falls toward the diversified rate, because a business that has crossed the next bridge is bought by diversified holders.
As at every anchor, no premium is added to the rate for the business's size or its particular risks. Each risk is placed once, in the cash flows, as a named scenario: the owner's successor failing, the largest customer leaving, a misstatement found in diligence, a co-owner leaving. None is also added to the rate, so none is counted twice.
Whether growth counts
The gate is stricter here than at SDE, because the record is longer. Growth counts only where the return on invested capital, on the definition fixed at the first anchor, exceeded the cost of capital in every year of the three-year record. One good year, or a good year and a weak one, proves little about persistence, and persistence is what this anchor's earned record is there to show.
Does growth count at this anchor?
The franchise gate is stricter here than at SDE. Check in order; the first failure means growth is valued at zero and any return above the cost of capital fades over a few years.
A persistent return is still not enough on its own. The barrier that explains it has to be named, and the evidence for it taken from the competitor map. The business's share and each named competitor's share must have held steady across the map's three years, with no entrant taking share that held. The barrier itself has to be shown, either as customers who stay and would bear a cost to switch, or as a cost advantage visible in gross margin against named competitors, and local scale counts only alongside captive customers. The map has to be recent: a gate tested on an out-of-date map is not passed. Where the gate is not passed, growth is valued at zero, and any return above the cost of capital fades to it over a few years.
Three layers, compared like with like
The valuation sets three figures side by side, all at the level of the whole enterprise before debt, so that they compare like with like. Debt is deducted once, afterwards, to reach the value of the equity. Reproduction value is what a competitor would spend to rebuild the business, now including the cost of writing and installing the procedures and systems this bridge created. Earnings power value is the current cash flow with no growth, normalized across the three-year record where it spans a cycle. The value of growth is whatever passes the gate. As at SDE, setting the three against each other is what produces the answer: it shows whether the business earns more than its assets would justify, and if it does, whether the evidence supports a reason.
Illiquidity and the conclusion
The usual holder at this anchor buys a controlling interest, so the discount for illiquidity is the cost and time of selling the whole business, and nothing else. It is computed from the transaction costs, the expected time to sell and the number of funds or strategic buyers active at this size and in this sector. Where a minority stake is valued, for a gift, an estate or a co-owner's buy-out, the holder's cash flows are the distributions the business has paid, and the discount is computed for that holder's position instead of being read from a table.
The three approaches are weighted by the strength of their evidence. With reviewed statements and a three-year record, the income approach is well supported, and comparable transactions are often plentiful at this size, so the two usually sit close together. When they do not, the gap is explained, and it is never closed by adjusting the income figure. The valuation is built before any offer, broker's opinion or comparable price has been seen. Every price that arrives afterwards is reversed into what it assumes, and a margin of safety is stated beside the conclusion.
Who underwrites it
The underwriter is a buyer who will not run the business. That buyer refuses to pay for earnings that depend on the owner's presence, decisions or relationships. Because it is partly diversified, its required return is lower than an owner-operator's, and the multiple it pays on the same cash flow is higher. That higher multiple is the reward for crossing the bridge.
What the crossing produced
The checkpoint at the end of the second bridge is what the third bridge inspects on its first day, and it falls into the same groups as the four spans. The financial records are three years of reviewed accrual statements with a proof of cash and the tax returns reconciled to them, a related-party schedule at market, and a schedule of adjustments reduced to documented one-off items. The management record is an organization chart with a named lead in every seat at benchmark pay under a written agreement, the written procedures, and a documented absence of the owner. The customer record is company contracts with every material customer and supplier, a customer schedule showing concentration and retention, and a liabilities file. The growth record is the sales engine's, from growth by source and retention by cohort to the pipeline, the price and volume bridge and the sales seat's results. With them go the inputs this valuation used. The essay on inspecting adjusted EBITDA sets out each in full.