Adjusted EBITDA: The Number Both Sides Better Get Right

The Reality Check That Kills Half of All LOIs

Every deal starts with adjusted EBITDA. Sellers pitch it. Buyers discount it. Banks underwrite against it. Get it too wrong and the deal dies in Quality of Earnings, wasting six months and six figures in fees.

Here's what happens. Educated seller or business brokers show $1M in adjusted EBITDA. Buyer models debt service coverage at 1.4x, writes the LOI. QoE provider comes in, removes $300K in adjustments. Real EBITDA is $700K. DSCR drops to 0.98x. Model doesn't work at the offer price. Bank won't fund the full loan. Purchase price renegotiations ensue. No agreement reached. Deal dead. Both sides lose.

Section One: What Is Adjusted EBITDA

The mechanics are straightforward but unforgiving. Start with net income. Add back interest, taxes, depreciation, amortization. Then adjust for non-recurring items, or expenses that aren't necessary to the continued operations of the business and won't reoccur. Every adjustment needs proof that satisfies three audiences: the buyer, their lender, and the QoE provider. Miss any of them and watch your deal unravel.

For buyers: Your LOI price divided by adjusted EBITDA sets your multiple. Overstate EBITDA by 20%, you overpay by 20%. Your sensitivity analysis better test every add-back.

For sellers: Every add-back that doesn't make sense gets rejected by the lender. Start proofing out the logic and support now, not when the QoE team arrives.

Section 2: The Add-Back Battle and What Survives Diligence

The question that unlocks everything: "What expenses disappear under new ownership?"

Owner compensation above market is the big one. Owner makes $400K. Market rate for a CEO is $150K. The $250K difference is an add-back everyone accepts.

But what if the owner works 70 hours across three roles? Buyers calculate replacement cost for all three roles. Sellers might argue that one competent manager can replace it all. This negotiation can swing EBITDA by $100-200K.

Personal expenses get interesting. Some are clear. The company box truck that moves equipment is a legit business expense. But the Company mid-sized SUV that's used for family vacations and golf outings isn't necessary, and the expenses related to that are a legit add-back.

The assistant that answers phones and sets meetings? No add-back. The family member who collects a check for "advising" or the overpaid family member whose retiring with the sale? Salary and expenses are legit add backs.

One-time events require proof they won't recur. That lawsuit settlement from 2022? Add it back if you can prove it's isolated. But if you've had three lawsuits in five years, buyers see a pattern, not an anomaly. A big inventory write-off? If it's a single expense on inventory made over the last 5 years, then its spread over the appropriate years, making it an add-back in the write-off year and a deduct in the prior(s). So it can go both ways.

A manufacturing company showed $800K adjusted EBITDA. The buyer's QoE found:

• Owner's $300K salary: only $150K accepted as excess (owner worked full-time)
• Personal vehicles ($40K): rejected, no usage logs
• Legal settlements ($75K): rejected, three incidents in four years
• Real adjusted EBITDA: $625K, not $800K

For buyers: Test each add-back with this: "Would my bank accept this?" If you're unsure, haircut it in your model. Build three scenarios: seller's number, conservative view, and doomsday case.

For sellers: Create an add-back folder now. Every receipt, every invoice, every proof point. The cleaner your documentation, the fewer arguments in diligence.

Section 3: Working Capital Normalization

EBITDA isn't the only adjustment. Working capital swings can crater deals faster than bad earnings. Think of it as the cash in the register and the mid-week wages that have been earned and not paid. It's the amount of quick-turning assets less quick-turning liabilities at any given time. Buyers need to know the real cash required to run the business. Sellers need to prove they're not manipulating the balance sheet.

The "peg" is your normalized working capital level. If the business needs $500K in working capital but only has $300K at close, buyer pays $200K less – usually out of a bucket set aside at close called "working capital escrow". If it has $700K, seller gets a $200K check. This true-up happens at close, with an adjustment period for confirmation, coming after months of negotiation of the peg. The required level at close is usually an average of the previous 12 months.

Buyers watch for games: Sellers stretching payables, collecting receivables aggressively, depleting inventory. A distribution business generated cash leading up to close. The true-up revealed they'd stopped buying inventory, and lived off of selling existing stock. Working capital at close was $400K below normal, purchase price proceeds dropped accordingly.

Sellers get surprised: Your seasonal swings matter. If you close in March when inventory is low but the peg is negotiated around June inventory levels, that's a problem. Calculate your twelve-month average now, figure out trends, sooner the better. Timing matters.

The math that matters:

• Current assets (excluding cash, equivalents, investments): $800K
• Current liabilities (excluding debt): $300K
• Working capital: $500K
• 12-month average: $450K
• Peg set at: $450K
• Adjustment at close: +$50K for seller (over purchase price)

For buyers: Pull monthly balance sheets for two years. Graph working capital. Look for trends, seasons, and any shifts away from norms. Your lender will.

For sellers: Normalize your balance sheet six months before selling. Stop the aggressive collections. Maintain steady inventory. Boring is beautiful in diligence.

Section 4: The Lender Reality That Trumps Everything

Banks don't care about your adjusted EBITDA thesis. They care about one thing: Debt Service Coverage Ratio (DSCR). Can this business pay its loans? Everything else is noise.

Minimum DSCR for most loans: 1.25x. Some conventional loans want 1.4x or higher. Miss these thresholds and less debt is funded at close, or there's a technical default. Sometimes you're allowed to put equity in to fix. Sometimes the debt is callable. Pay close attention to the term sheet with the lender.

Here's the brutal math:

• Adjusted EBITDA: $1,000K
• Less: CapEx required: $100K
• Less: Cash Tax Expense (Not book): $50K
• Free cash flow: $850K
• Debt service at 4x leverage: $650K
• DSCR: 1.31x (barely passes)

But what if EBITDA is actually $850K after QoE haircuts? DSCR drops to 1.08x. Loan amount requested is rejected. If the deal doesn't work at a higher equity stroke, its dead.

For buyers: Model a cushion for the DSCR. If it still works, proceed. If not, adjust the cap stack, lower your offer or walk. The bank won't bend their requirements for you. They can't.

Section 5: Your Pre-LOI Homework

For sellers: Understand that buyer's leverage constraints cap your price. At 4x EBITDA, they need 1.25x coverage. Add-backs will need to be valid, and don't change bank math.

Buyers: Before writing that LOI, build three models:

1. Seller's adjusted EBITDA as presented
2. Your "bad" case with 15-20% haircut
3. Your "worse" case with 30-40% haircut

If the disaster case breaks your DSCR or IRR thresholds, your offer needs to reflect it. If probable case works but seller's doesn't, negotiate pre-LOI. Once you sign, leverage shifts.

Sellers: Calculate your adjusted EBITDA three ways:

1. Your aggressive version with every possible add-back
2. Your documented version with proven add-backs
3. Your conservative version only obvious adjustments

Price expectations should use the documented version. Anything above is gravy. Anything below means you missed something.

If add-backs are legit, then the bank will sign off. If not, EBITDA changes. A $100K decrease and a 4x multiple is nearly half a million off the top. Close that gap before LOI, not during diligence.