Every price in private-company M&A is the product of two numbers: an earnings figure and a multiple applied to it. Owners fixate on the multiple. Acquirers spend most of their energy on the earnings figure, because that is where money moves quietly. On a company earning $2.4 million, winning an extra half-turn of multiple is worth $1.2 million, and everyone at the table will fight about it openly. A $400,000 disagreement about what the company actually earns, priced at 5.0x, moves $2 million, and it gets settled in spreadsheet footnotes while nobody is watching.
This chapter covers the earnings side of that equation and the definitions everything else in Part II depends on: what enterprise value and equity value mean and why confusing them is expensive, what EBITDA measures and what it hides, when seller’s discretionary earnings is the honest base and when it misleads, when revenue carries the price, and what period the earnings are measured over. Chapter 6 covers how reported earnings become adjusted earnings, Chapter 7 covers valuation methods, and Chapter 8 covers where multiples tend to sit. None of that can be negotiated well without the ground rules here.
The Worked Example: Meridian Industrial Services
Through the rest of Part II we will follow one hypothetical company, a composite assembled for illustration and not a real business. Meridian Industrial Services provides outsourced maintenance, repair, and plant-shutdown services to manufacturing and food-processing facilities across a three-state region. Its founder has owned it for 24 years and still runs it, with a plant-services division and a smaller controls division, about 90 employees, and a fleet of service trucks and specialized equipment.
The numbers that matter for our purposes: $12 million in trailing-twelve-month revenue and $2.4 million in reported EBITDA, a 20% margin, on internally prepared, accrual-basis financial statements. The balance sheet carries a $1.8 million equipment term loan, a $500,000 drawn balance on a working-capital line, and $400,000 of cash. Maintenance capital expenditures run about $300,000 a year. Chapters 6 and 7 will rework these numbers; for now, take them as reported.
When Meridian’s owner reads a headline or hears a number at an industry dinner, the first question should not be “what multiple?” It should be “a multiple of what, applied to what, producing what kind of value?” That is the rest of this chapter.
Enterprise Value vs. Equity Value: What a Price Actually Refers To
When someone says “I sold for $20 million,” the sentence is ambiguous in at least three ways. It might mean enterprise value, the headline on the letter of intent. It might mean equity proceeds, the amount that actually reached the owner before tax. And it might count contingent pieces (an earnout, a seller note) at full face value even though they have not been received and may never be. The gap between the most generous and least generous readings of that sentence is often a meaningful fraction of the number itself.
The two core terms:
Enterprise value (EV) is the value of the operating business itself, independent of how it happens to be financed. It is the price of the machine: the operations, contracts, people, equipment, and goodwill that produce the cash flow. When acquirers quote a multiple of EBITDA, the result is enterprise value. That convention holds throughout this guide.
Equity value is what the owners of the shares receive. It starts from enterprise value, subtracts the debt that must be paid off, and adds the cash the owner keeps. A homeowner already knows this arithmetic: the house sells for one number, and the seller’s wire is that number minus the mortgage payoff.
Lower-middle-market deals are almost universally struck cash-free, debt-free. The acquirer is buying the operations, not the owner’s bank balance or borrowing history. At closing, the owner keeps (or sweeps out) the company’s cash, and the company’s funded debt (term loans, lines of credit, equipment notes, and often items owners forget count as debt, such as capital leases) is paid off from the proceeds. What remains, after transaction costs, is the owner’s pre-tax equity proceeds.
One more adjustment lives in this bridge: the business must be delivered with a normal level of working capital, and a working capital true-up moves money in whichever direction the delivered level differs from the negotiated peg (Chapter 12 explains the peg and why it is fought over).
Illustrative example. Meridian signs a letter of intent at $12.0 million enterprise value, cash-free debt-free. (That happens to be 5.0x reported EBITDA of $2.4M; the round number is chosen for arithmetic, not as a pricing opinion.) The bridge from the headline to the owner’s pre-tax proceeds runs line by line:
| Line item | Amount |
|---|---|
| Enterprise value (the LOI headline) | $12.0M |
| Less: equipment term loan payoff | ($1.8M) |
| Less: working-capital line balance at close | ($0.5M) |
| Plus: cash retained by the owner | $0.4M |
| Less: transaction costs (advisory, legal, QoE, misc.) | ($0.6M) |
| Pre-tax equity proceeds | $9.5M |
Working capital is assumed delivered exactly at the peg, so no true-up. The owner “sold for $12 million” and will bank $9.5 million before taxes, which take their own bite later in the guide. Both statements are true. Only one of them funds retirement.
Key point. Multiples produce enterprise value; owners spend equity value. Confusing the two is the most reliable source of owner disappointment in lower-middle-market deals, and it is entirely avoidable: run the bridge from EV to net proceeds before you anchor on any headline number, not after.
Acquirers live in this bridge daily. Owners typically meet it once, late, and emotionally. The single cheapest piece of preparation in all of M&A is doing this arithmetic on your own company this week.
EBITDA: The Market’s Working Language
EBITDA is earnings before interest, taxes, depreciation, and amortization. In practice you build it by taking operating profit and adding back depreciation and amortization. It is not defined under GAAP, which is part of why Chapter 6 exists: “EBITDA” is a negotiated number wearing the costume of an accounting one.
The market standardized on EBITDA for reasons that are genuinely sound:
- It is capital-structure-neutral. Interest expense reflects how the current owner chose to finance the business. The acquirer will impose its own capital structure the day after closing, so the seller’s interest cost is noise.
- It is tax-posture-neutral. An S-corporation and a C-corporation running identical operations report very different tax lines. The acquirer’s tax position will be its own.
- It strips out non-cash charges shaped by history. Depreciation schedules reflect when assets happened to be bought and which elections were made, not what the operations earn this year.
- Lenders size debt off it. Acquisition financing is quoted and covenanted as a function of EBITDA. The number that determines how much an acquirer can borrow became, inevitably, the number that determines how much an acquirer can pay.
That is the case for EBITDA. Now the case against it, which every acquirer prices whether or not anyone says it out loud.
EBITDA ignores capital expenditures, and depreciation, for all its accounting arbitrariness, is the shadow of a real cost: equipment wears out and must be replaced with actual dollars. EBITDA treats that replacement as free. It also ignores working capital: a growing business absorbs cash into receivables and inventory before a dollar of that growth appears anywhere in EBITDA. And it is pre-tax and pre-interest, so it is nobody’s distributable cash flow. EBITDA is a comparability tool, not money.
The capex point is where two “identical” companies stop being identical.
Consider two hypothetical companies, each with $12 million of revenue and $2.4 million of EBITDA, the same headline profile as Meridian. Atlas Crane & Rigging earns its revenue on a fleet of cranes and heavy trucks; simply keeping that fleet certified and serviceable costs about $850,000 a year in maintenance capex before a dollar of growth spending. Beacon Industrial Testing earns its revenue with engineers carrying instruments; its maintenance capex is about $150,000. Same EBITDA. But the cash available before debt service and taxes is roughly $1.55 million at Atlas and $2.25 million at Beacon. Beacon throws off about 45% more cash from the same reported earnings, every year, structurally. No competent acquirer prices those two companies the same, and the market’s shorthand for the difference is to quote capex-heavy businesses at a discount, or to price them explicitly on “EBITDA minus capex.” If you own an Atlas, expect that conversation. If you own a Beacon, make sure your capex lightness is visible in the materials, because it is worth real money.
Meridian sits between these poles: its $300,000 of maintenance capex against $2.4 million of EBITDA is a moderate load, and acquirers will quietly run their debt models on the $2.1 million of EBITDA minus capex even while the negotiation is conducted in EBITDA terms.
A word on the alternatives. EBIT (operating profit, which keeps depreciation as a rough proxy for capex) is a better economic measure for asset-heavy businesses, and thoughtful acquirers of such businesses cross-check with it. Net income is nearly useless for pricing a private company: it sits downstream of the owner’s financing choices, tax elections, and discretionary spending, so two identical operations can report wildly different bottom lines. The practical hierarchy in the lower-middle market: EBITDA is the negotiating language, EBIT and EBITDA-minus-capex are the acquirer’s cross-checks, and free cash flow is what the acquirer’s model actually underwrites.
SDE: The Owner-Operator’s Measure
Below a certain size, EBITDA stops being the right base, because the owner is not just a shareholder: the owner is the general manager, the head of sales, and sometimes the senior technician. For these businesses the market uses seller’s discretionary earnings (SDE): EBITDA plus the total compensation and benefits of one full-time owner-operator. SDE answers the question an individual acquirer is actually asking: “if I buy this company and work in it full time, what is the total pre-tax, pre-debt economic benefit available to me?”
The two measures describe the same business from different chairs. A company with $625,000 of EBITDA after paying a $175,000 market-rate general manager has $800,000 of SDE if the owner holds that seat personally. Neither number is wrong; they assume different futures. SDE assumes the acquirer replaces the owner’s labor personally. EBITDA assumes the business pays market rate for management, because a financial acquirer will have to.
The practical dividing lines, with the usual caveat that the boundaries are conventions rather than laws:
- Owner-operated businesses with earnings below roughly $1 million to $1.5 million are quoted and sold on SDE. The buyer pool is dominated by individuals who will run the company themselves.
- Management-run businesses with roughly $1.5 million or more of earnings are quoted on EBITDA, with the owner’s compensation normalized to a market rate for whatever role the owner actually performs.
- The messy middle, roughly $1 million to $2 million of earnings, is decided by one question: does this company run without the owner? A $1.4 million-earnings business with a real general manager and a second layer of leadership is an EBITDA business. The same-sized business where the owner signs every quote is an SDE business, whatever its financials are labeled.
This is also where one of the most common self-inflicted valuation wounds occurs.
Common pitfall. Multiples travel through conversations without their bases attached. An owner with $800,000 of SDE hears that companies in his industry “trade at five times” (a figure quoted, somewhere upstream, on EBITDA for management-run companies) and multiplies it against his SDE. His actual EBITDA after a $175,000 market-rate manager is $625,000, so whatever the right multiple is, his mental price is inflated by 28% before a single negotiation has started. The reverse error is rarer but just as real: quoting an SDE-sized multiple against the EBITDA of a management-run company undervalues it. Every multiple you hear is meaningless until you know which earnings base it rides on.
When Revenue Is the Base
Sometimes the market prices a company on revenue rather than earnings. This is not because earnings stopped mattering; it is because current earnings deliberately understate what the business will earn at maturity. The classic case is high-growth software with recurring revenue: gross margins are high, the revenue base compounds under contracts, and reported EBITDA is low or negative because the company is reinvesting every gross-profit dollar into growth. Pricing that company on this year’s EBITDA would punish it for behaving rationally, so acquirers price the revenue (often specifically annual recurring revenue) and underwrite the margin structure it will support later.
The essential discipline is to see that every revenue multiple is an earnings multiple in disguise. Arithmetically, a revenue multiple equals an EBITDA multiple times an EBITDA margin. Meridian makes the identity visible: at $12.0 million of enterprise value, 5.0x EBITDA and 1.0x revenue are the same price stated two ways, because Meridian’s margin is 20%. Quote “1.0x revenue” for a 10%-margin services business and you have implicitly quoted 10.0x its EBITDA, which is a claim someone must eventually defend with earnings.
For most lower-middle-market companies, revenue multiples are a sanity check, not a pricing base. They flatter low-margin businesses in owners’ imaginations, and acquirers never forget the margin. Outside genuinely recurring, high-gross-margin revenue, an owner quoting a revenue multiple is usually an owner about to be disappointed by an earnings conversation.
Matching the Base to the Business
The three earnings bases, where each applies, and what to watch for:
| Base | What it measures | Typical territory | When it is the right base | Watch-outs |
|---|---|---|---|---|
| SDE | Total pre-tax, pre-debt benefit to one full-time owner-operator | Owner-operated; earnings below ~$1M-$1.5M | Acquirer will personally replace the owner’s labor | SDE multiples look “low” because the base is inflated by owner comp; never mix with EBITDA multiples |
| EBITDA (adjusted) | Earnings for a financial owner paying market-rate management | Management-run; ~$1.5M+ earnings (the LMM core) | Company runs without the owner; institutional or strategic buyer pool | Ignores capex and working capital; “adjusted” is negotiated, not audited (Chapter 6) |
| Revenue | Scale of the top line, margin structure assumed | High-growth software/SaaS, contractual recurring revenue; sanity check elsewhere | Current earnings deliberately understate steady-state economics | Every revenue multiple embeds a margin assumption someone must defend |
The lesson in the table: the base is not a preference, it is a description of who will buy the company and what they will do with it. Choosing the wrong base does not change the buyer universe; it just delays the correction until the buyer universe delivers it.
The Measurement Period: TTM, Fiscal Year, and Forward
With the earnings base settled, the next fight is over which twelve months of them.
Trailing twelve months (TTM) means the most recent twelve calendar months, rolled forward as each month closes. This is the acquirer’s anchor, for good reasons: it is the most current complete picture of the business, it contains a full cycle of seasonality, and it is the hardest period to cherry-pick. When acquirers quote a multiple, they overwhelmingly mean a multiple of TTM adjusted EBITDA.
Fiscal-year figures matter because that is where the best financial statements live: reviewed or audited statements, filed tax returns, clean cutoffs. But a fiscal year goes stale fast. By September, last December’s numbers are nine months old, and a business trending up is undersold by them while a business trending down is oversold. Diligence will reconcile TTM to fiscal-year statements in any case, which is one reason monthly closes that tie out cleanly are worth so much (Chapter 6 returns to this).
Forward and run-rate numbers are where owners want to live and acquirers refuse to. Every owner selling a growing company feels the injustice of being priced on the past. The run-rate argument (annualize the recent months, count the signed contract, credit the price increase) is legitimate exactly to the extent the step change is contractual, already in effect, and visible in the numbers. Meridian’s owner put through a price increase in March; by the time a deal closes late in the year, most of it is in TTM and needs no argument. The unproven remainder, and next year’s budget generally, is something acquirers typically bridge with structure rather than price: they will share the upside if it arrives, not pay for it in advance.
Two practical implications follow. First, TTM is a moving target: in a process that runs six to twelve months, the anchor number gets refreshed with every monthly close, which is why business performance during the sale process has such outsized consequences. Second, timing is a legitimate preparation tool. An owner whose improvements land in the trailing numbers before going to market sells proven earnings; an owner who goes to market mid-improvement sells an argument.
The Bottom Line
- Every price is an earnings base times a multiple, and the base is negotiated before the multiple conversation even starts; owners who only prepare for the multiple fight lose the quieter, larger one.
- Multiples produce enterprise value; owners spend equity value. Run the EV-to-proceeds bridge (debt off, cash back, costs out, working capital trued up) before anchoring on any headline.
- EBITDA is the market’s language because it is comparable and financeable, not because it is cash: capex and working capital are real, and acquirers price them whether or not they say so.
- Match the base to the business: SDE for owner-operated companies, adjusted EBITDA for management-run ones, revenue only where earnings deliberately understate the future. A multiple without its base is a rumor.
- Acquirers anchor to trailing twelve months, so proven earnings beat projected ones; sell after improvements land in TTM, and protect the trailing numbers ferociously while a process is live.