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

This is the first issue of a new format I'm trying. Each week I'm going to take one term, clause, or mechanic from the PE world and break it down in plain English. The kind of thing that comes up in your first meeting with the deal team and you nod like you understand it because everyone else seems to (one of my best party tricks is convincingly nodding my head at someone when I have zero idea what they’re talking about. This includes TV shows I’ve never seen and bands I’ve never heard of).

Today's term: EBITDA. Specifically, the fact that there are two of them, they don't match, and you're expected to know which one is being discussed at any given moment without anyone telling you.

About three months into my CFO seat, my deal partner asked me on a Tuesday call what our trailing twelve month EBITDA was. I told him $14.2M. He paused for a second, looked at his notes, and said, "I have you at $11.8M."

Neither of us was wrong. We were just looking at two different numbers that both had the right to call themselves EBITDA.

If you've been a portco CFO for more than a few quarters, this has probably happened to you. If you're newer to the seat, it's coming.

You already know what EBITDA is. Earnings before interest, taxes, depreciation, and amortization. Take net income, add back the four things, get a number that approximates operating cash generation before the capital structure gets involved.

That's the textbook version. It's also not the one that matters in your job. Theoretically correct and practically kinda useless.

When your company got bought, the credit agreement that financed the deal contained a defined term called "Consolidated EBITDA" or sometimes "Adjusted EBITDA." It runs anywhere from one to four pages of legal definition. It's the EBITDA that determines whether you're in compliance with your debt covenants, how much you can borrow on the revolver, and whether your sponsor can pay themselves a dividend recap.

That number is calculated according to the credit agreement, full stop. There is no judgment involved. If the document says you can add back $X for "non-recurring restructuring expenses up to a cap of 10% of EBITDA," then you do exactly that, and the lender's agent will agree or disagree based on the four corners of the document.

Then there's the EBITDA your sponsor uses to track value creation against their underwriting model. This is the “management EBITDA”. It's the number that shows up in the operating partner's quarterly review. It's the number that gets trended on the slide that says "EBITDA expansion since acquisition." This number can include or exclude things at the sponsor's discretion, because it's their internal scorecard, not a contract with a lender.

Then there's the EBITDA that will show up in the management presentation when your sponsor sells the company. This is the third one. It's the most aggressive of the three because the seller's job is to convince the buyer that the company generates the maximum defensible cash flow, so the multiple gets applied to the highest possible base.

So you actually have three EBITDAs running at the same company at the same time.

They all answer slightly different questions. Yet they all use the same word.

The thing that makes this confusing is that nobody ever sits you down and tells you which one is being referenced. They just say "EBITDA" and assume you know from context.

Let's say your business does $50M in revenue and you have a few non-recurring items in the trailing twelve months.

Now, the add-backs.

Credit agreement EBITDA: The credit agreement says you can add back severance, settled legal expenses, and transaction costs related to permitted acquisitions, but caps total add-backs at 25% of standard EBITDA. So $10.0M plus $2.7M of add-backs, capped at $2.5M (25% of $10.0M). Result: $12.5M.

Management EBITDA: Your sponsor's internal model adds back everything in the credit agreement version, plus stock-based comp, plus the cost of an interim VP of Sales they had to backfill, plus a piece of the founder's compensation that they consider above-market. Result: $13.8M.

Deal EBITDA (when you eventually sell): The bankers will add back everything in the management version, plus an estimate of "synergies the next owner can capture," plus a "run-rate" adjustment that pulls forward the savings from a recent reorganization that hasn't been in place for a full year. Result: $15.4M.

Same business. Same trailing twelve months. Three different EBITDAs, ranging from $12.5M to $15.4M. And a 23% spread on the same number, depending on which EBITDA you're using.

Back to the Tuesday call where my deal partner had me at $11.8M and I had me at $14.2M.

I had been using the management EBITDA from our internal monthly close package, which included a few add-backs the deal partner's number did not. He had been using the credit agreement EBITDA from the most recent quarterly compliance certificate, because he was prepping for a conversation with the lender about a potential incremental facility and that was the only number that mattered to the lender.

We were both right. We were both also wasting fifteen minutes of a thirty minute call trying to reconcile two numbers that were never supposed to be the same.

What I learned from that call: when EBITDA comes up, ask which one. Specifically. Every time. "Are we talking credit agreement EBITDA or management EBITDA?" is not a dumb question. It's the question that prevents the next forty minutes of confusion. Clarity is kindness to all involved.

I also started building a one-page bridge in our monthly close package that walked from GAAP operating income to standard EBITDA to credit agreement EBITDA to management EBITDA, with every add-back and exclusion footnoted. It took my FP&A team about two hours a month to maintain. It saved everyone hours of confusion every quarter. And I felt so much better having it in my back pocket.

Three things, all of them small.

Wishing you the EBITDA definition that flatters your business the most,

CJ

Looking for Leverage breaks down one PE term, clause, or mechanic each week, written for the CFOs and finance leaders who actually have to live with these things. If this got forwarded to you, subscribe at lookingforleverage.com. If there's a term you want broken down, reply and tell me. I read everything.

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