Say you pay $5.25M, or 3.5 times, for a Midwest machining company with $1.5M of adjusted EBITDA. If you invest in growth in year one, as many of you plan to, it is reasonable to expect only about $177K of after-tax distributions that year, on top of your $150K salary. But why is there such a discrepancy? The quality of earnings review held up. Every adjustment was supported and the cash proof tied, so the price was set on a fair number. In short, the deal is priced on adjusted EBITDA, but what you live on is the cash left after capital spending, income taxes and debt service, and that figure is worth building yourself before you agree to the price. What the price was built on We all know this by now, but just in case, EBITDA excludes interest, income taxes, depreciation and amortization. This definition of earnings strips out a company’s financing and investing decisions and leaves just the operation. Our example deal is priced on adjusted EBITDA, which already carries a $150K market salary for whoever runs the company. Seller’s discretionary earnings adds that salary back on top of EBITDA, so SDE here is $1.65M. Intermediaries often quote small and medium-sized businesses (SMBs) on SDE, and a Small Business Administration (SBA) lender tests coverage on SDE too. Our example’s growth plan for the first year after close is to hire an outside salesperson at about $100K loaded and a second-shift lead at about $80K and to buy a $500K machine on a ten-year equipment loan, with the goal of growing revenue 25 percent, from $8M to $10M by the end of year three. All of that spending happens in year one, which we call the investment year, and the expectation is that revenue reaches about $9M in year two and $10M in year three, with the new revenue earning a 30 percent contribution margin. The exhibit below reconciles SDE down to after-tax distributions for the same company in the trailing twelve months repeated, the investment year, years two and three on plan, and a year two in which the growth does not come through. Every figure is illustrative. redactedIn the steady-state year, which just means the trailing twelve months from the quality of earnings with no additional hires, no new machines and no working capital build, you draw the $150K salary and about $352K of after-tax distributions on top of it. Those distributions work out to roughly 23 percent of adjusted EBITDA, after about $240K a year of capital spending to keep the existing equipment running, income taxes on a pass-through entity, and about $700K a year of principal and interest on a $4.46M SBA 7(a) loan at 9.75 percent over ten years, with 10 percent down and a seller note on full standby. We call that equipment spending maintenance capex, and it comes out of cash every year whether or not you grow, even though none of it shows up in EBITDA. Spending on additional manufacturing capacity, like the new machine in the growth plan, is called growth capex. When you review a target company’s history, ask the seller and your quality of earnings provider to split historical capital spending between the two, because a seller who labels most of it as growth is telling you the business costs less to keep running than it really does. In the investment year, distributions drop to $177K and stay there in year two, because the working capital behind the year-three revenue has to be funded a year early; if the plan works, they reach $512K in year three on a now larger EBITDA, and coverage ends up better than it was in steady state. The investment year requires cash up front Each piece of the growth plan requires cash up front, and the earnings it produces usually lag by several months, which is largely why distributions in the investment year come in so low. In a machining company where quoting cycles run for months, I would assume a new sales hire returns nothing meaningful for the first six months and breaks even after month twelve. The second-shift lead is a full cost from the day they are hired. The new machine is your growth capex, and on a ten-year equipment loan its payment goes into the same coverage test as the SBA loan. Moreover, the receivables and inventory behind the new revenue have to be funded months before any of the margins show up in EBITDA. How long does the growth plan take? Stanford’s 2024 search fund study notes that searchers typically make few significant changes in the first six to eighteen months after close. Seller forecasts are not much help either. Yale’s 2025 review of 44 search-acquired companies found that CIM forecasts projected margins up about six points by year four, when margins actually fell about ten. Years three and beyond are where the plan likely pays, and the exhibit below shows distributions staying low for the first two years, then moving past steady state in year three if the growth comes through. redactedIf the growth does not come Look at the last column of the first exhibit, year two with the growth missed. The hires and the machine are bought, but the revenue does not follow, and the lender’s debt service coverage ratio (DSCR) is now 1.2 times against a 1.25 times floor. Most lenders write this test into the loan agreement as cash after capital spending and income taxes, divided by all debt service. Because it is measured on the trailing twelve months, the spending shows up in it right away, and the revenue it was meant to produce has not arrived yet. SDE over debt service is still about 1.9 times in that year. Lenders underwriting a 7(a) loan typically use that test to approve it, but the covenant in the loan agreement is the one measured after close, and that is the one that trips. This is why it matters that the investment you make in the years after close actually pays off; without a return on it, the bank’s questions become a little less friendly. In practice, a breach usually means a waiver fee, a request for more equity, or a hold on distributions until coverage recovers. Watch the cash cycle in year one redactedAt a 65-day cash conversion cycle, each day the cycle slips takes about $22K out of the bank with no change to EBITDA. Two common reasons it slips after a close are a large customer stretching its payment terms and vendors who were paid slowly before the sale asking a new owner for normal terms. If days sales outstanding (DSO) is increasing or days payable outstanding (DPO) is decreasing after the sale, operating cash flow will continue to shrink below what the EBITDA on your target company originally indicated. Ten days of slippage is about $220K, which is more than the investment year’s distributions. What I would do before the LOI I would build the walk myself before the LOI number is set, starting from the EBITDA the deal is priced on and taking out my own pay, the maintenance capex from the asset register, the income taxes on the structure I am actually using, every piece of debt service, and the working capital the growth plan will consume. I would price the deal on what is left, and if that number does not support the growth plan, I would want to know before signing. The levers at that point are the price, a larger seller note on standby, or a slower growth plan. Each of those is easier to negotiate before the LOI than after. A quality of earnings review is where that walk gets tested against the bank statements, and having built it first, I would know which numbers to focus on when I read the report. Coming up: getting diligence-ready a year or two before a sale, and why the owners who start early are usually the ones whose numbers hold up in that review. Ryan Anoskey, Partner, LIMESTONE.