Key terms for this section
The process of independently recreating the seller's EBITDA from source documents - the general ledger, bank statements, and tax returns - to confirm it is real, sustainable, and accurately represents future cash generation.
An expense the seller adds back to reported profit to show higher underlying earnings. Add-backs are legitimate when documented and truly non-recurring. They are not legitimate when vague, recurring, or unsupported.
For undocumented add-backs: give 50% credit, not 100%. If a seller claims $100K in personal car expenses but has no documentation, assume $50K is legitimate and reject $50K. Conservative enough to protect you, fair enough to avoid a fight.
EBITDA after removing documented non-recurring items and adding back missing expenses that will hit you post-close. This is the number your price should be based on.
Real operating costs that are not on the current books but will appear after close: market-rate salary to replace what the owner was doing, health insurance not in the P&L, deferred maintenance, professional fees.
The four-step earnings quality process.
A 4-step process for the four-step earnings quality process.
- Step 1: Recreate EBITDA from the general ledger Do not start from the seller's P&L. Start from the general ledger and build EBITDA yourself, line by line, for the last 24 months. Compare each month to the bank deposits. Investigate any line item variance above 5% that you cannot explain (Step 1)
- Step 2: Validate each add-back with documentation The seller claimed add-backs in your pre-LOI work. Now you need proof: invoice, receipt, contract, or a clear written explanation. Apply the 50% rule to anything undocumented. Do not give credit for vague or unsupported items. 'I probably s (Step 2)
- Step 3: Adjust for missing expenses Find the costs that are not on the books but will hit you after close. Market-rate replacement salary if the owner is underpaying themselves. Health insurance if they are on a spouse's plan. Deferred maintenance on aging equipment. Legal, a (Step 3)
- Step 4: Build three normalized EBITDA cases Conservative: 50% of undocumented add-backs are real, include all missing expenses identified. Base: 75% of undocumented add-backs are real, include moderate missing expenses. Optimistic: 100% of add-backs are real, minimal missing expenses (Step 4)
- Recreate EBITDA from the general ledger transforms Validate each add-back with documentation: Step 1 naturally follows from the prior action.
- Validate each add-back with documentation transforms Adjust for missing expenses: Step 2 naturally follows from the prior action.
- Adjust for missing expenses transforms Build three normalized EBITDA cases: Step 3 naturally follows from the prior action.
How to present EBITDA findings to the seller.
Decision gate for how to present ebitda findings to the seller. Proceed when: Normalized EBITDA is within 10% of your initial underwriting.
- Reconsider: Gap is 10 to 20%. Adjust price or structure. The deal can still work if the seller accepts revised terms.
- Proceed: Normalized EBITDA is within 10% of your initial underwriting.
- Walk: Gap exceeds 20% and the seller will not accept a material adjustment. Do not talk yourself into a deal where the economi
- Reconsider: Gap is 10 to 20%. Adjust price or structure. The deal can still work if the seller accepts revised terms.
EBITDA is the foundation everything else rests on
Every other number in the deal - price, structure, earnout targets, return projections - inherits from your normalized EBITDA. Getting this wrong by 15% and not catching it until close is the most common and most expensive mistake in lower middle market acquisitions.
This course is operational guidance, not investment, legal, tax, or financial advice. SilverShore Partners is not a registered broker-dealer or investment adviser; in qualifying private-company transactions we may operate within the federal M&A broker exemption under Section 15(b)(13) of the Securities Exchange Act. Confirm specifics with your own advisors.