Hi, it's CJ Gustafson and welcome to Looking for Leverage.

Today's term: cash conversion, or how much of your adjusted EBITDA actually makes it to the bank account.

When adjusted EBITDA and the bank balance disagree, your sponsor eventually believes the bank balance.

Rock beats scissors.

I was talking with Brian Neider of Lead Edge Capital, whose firm put together one of my favorite charts in finance: a hierarchy of the metrics companies brag about when they don't have profits to brag about.

It's basically a hierarchy of bullshit metrics, and for good reason it still gets passed around finance circles every couple of years.

I asked Brian how he thinks about a company reporting strong adjusted EBITDA without producing much cash. He gave me one example of a business with no debt that had reported positive adjusted EBITDA for years and still hadn't produced meaningful free cash flow.

Brian described another company that, depending on which exhibit you were looking at, could reasonably be called a $58M adjusted EBITDA business, a $38M EBITDA business, or something closer to a $25M free cash flow business once you worked through the adjustments and checked what was actually hitting the bank account.

There are really two questions buried in there:

When I asked Brian for the craziest add-back he'd seen, he rattled off the usual founder-led company stuff: the owner's boat, the owner's plane, the owner's kid's birthday party.

The funny part is those don't bother him that much. If Lead Edge buys the business and the owner's plane goes away the next day, you can make a pretty reasonable case for taking it out of the earnings you're underwriting.

The harder ones are expenses that everyone keeps calling unusual even though some version of them shows up every year.

Brian used recruiting fees as an example. Maybe the company had an unusually big hiring year and leaned heavily on headhunters, so management adds the fees back as non-recurring. That's defensible once. But as the company gets bigger, turnover grows with it, hiring never really stops, and after two or three years I'd have a hard time continuing to call the expense one-time.

As Brian put it, it's "not the same exact thing that happens every year, but it rhymes."

You see a different version of this with run-rate adjustments.

Say you restructure the team in September and expect to save $2M annually, but most of the people and costs don't actually come out until the following year. The adjusted EBITDA bridge may give you credit for the full savings today even though you're still paying the costs.

Brian said he's seeing this in AI businesses too, where a company will show normalized COGS based on token costs continuing to fall or workloads eventually moving onto cheaper models.

Those can be perfectly reasonable assumptions for an investor to make about where the business is headed. I wouldn't put them in the historical financials before they happen.

Then you have costs that EBITDA doesn't see in the first place.

If your engineers are building qualifying software, part of their salaries can be capitalized onto the balance sheet rather than running through the P&L immediately. You still paid them every two weeks.

Sales commissions have a similar timing issue. You may pay the rep the full commission when the deal closes and then expense it over the expected customer benefit period, so in a fast-growing company there can be a meaningful gap between commission cash paid and commission expense running through the P&L.

I'd especially pay attention when adjusted EBITDA is improving at the same time the percentage of engineering payroll getting capitalized is increasing. Nothing nefarious has to be happening. You just need both numbers to understand what happened to cash.

Working capital is probably the more familiar culprit.

A rep gives a customer 60 days to pay instead of 30 to close the deal. The implementation team finishes the work in March but billing doesn't send the invoice until April. A customer who used to pay annually upfront negotiates quarterly payments.

All three can produce the same revenue and EBITDA with very different cash timing.

Growth makes this a little trickier because a company growing 30% should have more receivables sitting on its balance sheet. I'd split the increase into what came from having a bigger business and what came from taking longer to collect the same dollar of revenue.

If DSO went from 50 days to 58, that's eight days I'd want back.

Prepaids go the other direction. Maybe you wire a cloud provider three years of cash upfront to lock in better pricing, while only one-third of the expense hits the P&L in year one. Annual software contracts and inventory purchases can create the same timing issue.

You may have made a great purchasing decision. You also wrote the check.

Take an $80M software company, up from $70M last year, reporting $16.0M of adjusted EBITDA.

Here's what happens on the way to the bank:

That's 34% cash conversion.

A few of those lines deserve a closer look.

The $3.0M of add-backs includes $700K of recruiting fees and $400K of "non-recurring" consulting, both of which also showed up last year in some form.

The $800K run-rate adjustment is savings from a reorganization that won't be fully implemented until next year.

Of the $3.1M receivables build, roughly $1.4M came from growth and another $1.7M came from DSO stretching from 50 to 58 days.

And the company wired $900K to its cloud provider for a three-year commitment, while only $300K of it ran through this year's P&L.

The IRS, sadly, wanted another $1M in actual cash.

I like the bridge because you can stop arguing about whether 34% is "good" or "bad" and start talking about the individual lines. I'd feel very differently about the $1.4M of receivables created by growth than the $1.7M created by customers taking eight extra days to pay.

I learned part of this lesson on sales commissions.

We were having a huge sales year, and I made the call to capitalize our commissions. It made sense at the time: reps were getting paid large commissions on multi-year deals, and expensing all of it upfront would have made the P&L look like we were being punished for winning.

About 18 months later, I was going through the P&L and kept seeing commission expense that didn't line up with what sales had actually closed that quarter.

I spent a solid afternoon asking where these other costs were coming from before it hit me that they were mine.

They were the amortization from those big deals, working their way through the P&L exactly the way I'd set them up.

The cash had gone out the door a year and a half earlier. I had just gotten far enough away from the original transaction that I forgot what I was looking at.

Wishing you an adjusted EBITDA that survives the trip to the bank,

CJ

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