EBITDA Is Not What the Owner Gets to Keep

The earnings used to price an acquisition can look very different from the cash available after reinvestment and debt payments. The deal documents need to reflect that difference.

A business reports $2 million of EBITDA. After interest, taxes, equipment spending, working-capital investment and debt repayment, the illustrative cash available to equity is $450,000.

The earnings have not necessarily disappeared. They have other jobs to do.

A buyer may negotiate the price using an EBITDA multiple, then discover that the business must support acquisition debt, replace equipment and fund customer growth before it can support owner distributions.

Your Balance Sheet Is Also a Contract examined the rights behind reported assets and obligations. The next question is what those rights, obligations and operating needs leave for equity.

Build the bridge before relying on the multiple

Free cash flow to equity, or FCFE, estimates cash available to equity after operating costs, taxes, reinvestment and debt cash flows. It differs from the dividends actually paid. CFA Institute, Free Cash Flow Valuation

Illustrative annual EBITDA-to-FCFE bridge

EBITDA: $2,000,000

Less cash interest: ($250,000)

Less cash taxes: ($200,000)

Less capital expenditures: ($500,000)

Less increase in working capital: ($300,000)

Plus net borrowing: ($300,000)

Illustrative FCFE: $450,000

FCFE = EBITDA − cash interest − cash taxes − capital expenditures − increase in working capital + net borrowing.

Net borrowing means new debt issued minus principal repaid. Here, repayments exceed new borrowing by $300,000.

This simplified bridge assumes consistent annual figures, cash taxes reflecting the modeled financing, and noncash operating working capital excluding cash and interest-bearing debt. It assumes no other material reconciliation items. Adjusted EBITDA, leases, noncash charges and transaction costs may require further adjustments. Depreciation is already excluded from EBITDA; do not add it back again. Damodaran, Variable Definitions

The example measures a post-closing operating year, not the acquisition’s closing funds flow. Borrowing used to pay the seller is not spare operating cash. More borrowing can increase measured FCFE without improving the underlying business.

Determine what operating liquidity arrives at closing

The model’s increase in working capital describes additional cash tied up during the period. The purchase agreement’s closing adjustment addresses a different question: what agreed level of operating assets and liabilities does the seller deliver?

Define the working-capital target, often called the peg, using the actual business and its seasonal needs. Then specify included accounts, exclusions, accounting methods and dispute procedures.

Cash and debt commonly receive separate treatment, but the contract must establish that treatment. Customer deposits, overdue receivables and accrued expenses deserve deliberate classification. Avoid counting one exposure in working capital and again as debt or another deduction.

A price adjustment also does not necessarily put cash into the operating account. Counsel, the buyer and lender should reconcile the adjustment with closing funding and the business’s opening liquidity.

Find the spending needed to sustain the earnings

Historical depreciation is an accounting allocation. It does not establish what replacing worn equipment will cost next year.

Request maintenance records, asset ages, replacement estimates and the capital budget. Separate spending needed to sustain current operations from spending intended to expand them, then test whether the earnings forecast is credible without either.

If maintenance has been deferred, decide how the deal will address it: price, a pre-closing repair obligation, a specific closing condition or another negotiated allocation.

A model showing the cash shortfall does not make the seller responsible for fixing it.

Put the debt at the right level

Interest pays for using borrowed money. Principal repayment returns it. EBITDA deducts neither, so both matter when estimating cash available to equity. Damodaran, Cash Flows

Model the proposed acquisition financing rather than carrying forward the seller’s historical debt costs. Recalculate cash taxes with the tax advisers; book tax expense is not necessarily cash tax, and pass-through structures require identifying whose taxes are being modeled.

Location matters too. If acquisition debt sits at a holding company, operating-company cash may need to move upstream to service it. Trace that movement through both entities and their documents without counting intercompany transfers twice.

A consolidated model can look adequate while the entity owing the payment cannot access the cash.

Cash available to equity is not a distribution authorization

Seller-note interest and principal belong in the appropriate debt cash flows. Earnout payments require separate treatment consistent with their structure. A rollover investor may share distributions, so total FCFE is not automatically the acquiring buyer’s personal cash.

Lender-required standby terms may defer seller payments. Distribution restrictions, minimum-liquidity requirements and debt-service tests can constrain cash movements. Read the actual agreements rather than treating the model as permission.

Entity law matters as well. For example, Delaware corporate dividends are subject to statutory financial conditions and charter restrictions; FCFE is not the statutory test. Delaware General Corporation Law § 170

The company may also retain cash for reserves or growth beyond the spending already modeled. Do not deduct the same reinvestment twice, but do not assume every remaining dollar should leave.

Make the findings change the documents

Before the LOI, identify which cash assumptions materially affect price, financing and the buyer’s ability to operate. Address the important principles early while clearly reserving unresolved mechanics.

The purchase agreement should then translate those principles into definitions, schedules, adjustments, covenants, conditions and remedies. Financing documents must support the same payment sequence.

The buyer, CPA or QoE provider and lender establish and test the financial assumptions. Counsel helps turn the resulting decisions into obligations the documents actually address.

An EBITDA multiple can begin the valuation discussion. It cannot finish the cash analysis.

Before signing, know what the business must fund, what the financing permits and what remains for the equity being purchased.

Discuss the cash assumptions behind your acquisition with Tolbert Legal, including how they should appear in the LOI, purchase agreement and financing documents. Start a transaction conversation.

General information for educational purposes only; not legal, tax, accounting, financing or investment advice. Figures are hypothetical and do not represent a client matter, valuation or expected return. Results depend on the business, entity structure, documents, assumptions and applicable law.