3 Advanced Lessens from Reichman University ETA Class #2

The following are 3 lessons that Guy Solomon and I covered in our second ETA Class 1. The quality of the books often reflects the quality of the seller. Story: I looked at a services business where 32% of EBITDA was add-backs. Some were standard owner perks. Others were less defensible -- personal charges run through the business by employees who had learned the culture from the top. When the QoE accountants started digging, new items kept surfacing. At a certain point, the issue was not the add-backs themselves but the fact that I could no longer anchor to any number with confidence. We had gone under LOI twice and spent $15-20K on outside accountants before concluding that the books were simply too unreliable to price the business. Lesson: Everyone knows to adjust for owner perks. The subtler point is that messy financials are not an isolated problem. They are a signal about how the business has been managed. An absentee owner with unreliable books has been running everything else the same way. If add-backs approach 30% of EBITDA you may not just looking at an accounting problem. You may be looking at a management culture. 2. Stable revenue is not the same as durable revenue. Story: I once looked at a specialty manufacturer doing ~$12M in revenue, $2M in ebitda flat for five years. Looked rock solid. When I pulled the customer-level data, the top customer had nearly doubled its orders over that period. Every other customer, in aggregate, had declined by almost the same amount. The business was in systematic attrition, masked entirely by one relationship. The CIM said nothing about it. Lesson: Flat aggregate revenue across four years is not a green flag. Pull the revenue by customer, look at the trend in every account except the top one, and ask what you are left with. If the non-top cohort is shrinking, you do not have a stable business. You have customer concentration dressed up as consistency. 2. The opportunity is often in seeing a business threw a different lens than other buyer. Story: I looked at a waste management intermediary that appeared to generate 9% EBITDA margins on $30M in revenue. After removing the pass-through subcontractor costs it billed to customers, the business retained about $4.7M in gross spread and generated roughly 58% EBITDA margins on what it actually owned. Completely different business. Would have been screened out in the first pass by anyone applying standard margin filters. Lesson: Intermediary businesses bill pass-through costs as revenue. It is not. On the economics it actually controls, the margin may be 55-60%. Before you run any margin analysis, establish what the company actually keeps. Reclassify pass-through costs. Then run your numbers. 3. Earnings volatility is a capital structure problem Story: I spent significant time on a seasonal exterior services business. Calendar year P&L looked reasonably stable. When I re-sliced the same financials by the actual winter to summer economic cycle that drove the business, gross profit swung from $1.3M in a bad year to $4.8M in a strong one -- a 3.7x range. The seller had owned it for 20 years unlevered and genuinely did not understand why I cared which year the money came. I understood it perfectly: I would be servicing debt through the trough regardless of what the ceiling eventually looked like. Lesson: A seller who has run an unlevered business for 20 years does not care which year the big number comes. He averages it out. You cannot. You have bank debt, IRR pressure, and investors who expect distributions. Two bad years followed by a great year is a very different outcome for a leveraged buyer than the same numbers in reverse.