Valuation & the Waterfall

Key Principle

Valuation is not "How much?" It is amount × timing × probability of cash. A headline price is a single number; cash is three variables. The same headline can hide wildly different real economics, because two mechanisms corrupt it: the waterfall corrupts amount (you don't get the whole number), and structure/terms corrupt timing and probability (you don't get it now, and may never). The real question is "how much money traded, under what conditions and terms, for what level of ownership of the business, and behind what debt."

Why This Matters

A seller who negotiates the headline number is optimizing the figure that carries the least information. A $10M all-cash, all-equity offer with no contingencies or clawbacks is "a heck of a lot more valuable" than a $10M offer split into $5M senior debt + $2M sub debt + $1M seller note + $1.5M earnout + $500K equity — same headline, but the second pushes most cash into the future and makes it contingent. Whoever controls the structure controls the real money: "You set the price and I'll set the terms."

Valuation is always a multiple of "something" — SDE, EBITDA, EBIT — or a DCF, all of which estimate the present value of future cash flows. The base earnings figure is negotiable (normalization / add-backs), and because the multiple amplifies every disputed dollar, that is where deals are won or lost. Because deals take 6–18 months to close, price is tied to a multiple of adjusted trailing-twelve-month (TTM) figures — favorable if the company keeps performing, stressful if it turns down. The seller carries performance risk through the long closing window.

Good Examples

The Waterfall (worked example). Sale proceeds are paid out by priority, not proportionally. Payment order — each tier consumed before the next reaches a dollar:

Senior debt → subordinated/mezz debt → seller note → preferred equity (incl. liquidation preferences) → common equity (incl. rolled equity).

$100M sale: $50M senior debt, $20M sub debt, $10M preferred with a 2X liquidation preference (pays out $20M). That is $50M + $20M + $20M = $90M consumed before common; $10M left. A 20% common owner receives just $2M — "perhaps surprisingly." The liquidation preference is the hidden multiplier; preferred dividends and returns "automatically dilute other owners," are "rarely disclosed," and make a rosy valuation far less rosy.

Multiple ranges by size (Pepperdine Private Capital Markets Project; PitchBook; Pratt's Stats; The Business Reference Guide; GF Data; Harvard; Stanford):

Multiples rise with size: bigger, less owner-dependent businesses are scarcer and lower-risk. SDE (seller's discretionary earnings) includes owner compensation and is used for small, hands-on, owner-operated firms where the buyer becomes the operator; EBITDA ("B.S. earnings") excludes it and is used for larger firms — which is why SDE-priced small firms sit at the bottom of the range and EBITDA-priced larger firms at the top.

The headline number is fragile. Same company, one year of data, valid valuations from ~$14M to ~$24M depending only on which earnings figure and multiple a buyer picks: 5X two-year EBIT blend = $14.375M; 4X last year's EBITDA = $17.6M; 4.5X TTM EBIT = $16.2M; 3.5X TTM EBITDA = $14.875M; 4.75X projected EBITDA = $23.75M. A buyer's interpretation of the same history can shift value ~70%.

The leverage discount on rolled equity. "If you sell 70% of your company and most of the cash at closing came from debt, the 30% you retain will be worth considerably less than the same 30% before the transaction." Rolling equity converts a clean stake into a levered, subordinated one: it now services 30% of debt that did not exist before, and sits behind senior, mezz, seller, and preferred claims. The "second bite of the apple" is worth less than the identical pre-deal stake — its value depends entirely on the waterfall.

Counterpoints

• The multiple ranges and norms are not laws: "the norm doesn't matter. It's whatever you negotiate." Transaction value typically excludes existing long-term debt and cash (buyer wants a clean slate) and includes working capital — but every line is negotiable, so two offers aren't comparable until normalized to the same definition.
• A declining company may get only 3.5X from a passive buyer but 5X from a strategic who can restore performance; a cyclical company gets a multi-year earnings blend; a fast-grower can earn 8X TTM. The multiple is a judgment about probability of future cash, not a fact.
• Macro matters: cheap money (near-zero rates through the 2010s–early 2020s) let PE equity run as low as ~15% of closing cash and pushed multiples up; at ~9% borrowing from 2023, buyers grew "more disciplined about both valuations and how much leverage should be employed." The same company is worth more in cheap-money years.

Key Quotes

"On a financial basis, what matters is the amount, timing, and probability of cash." — Brent Beshore, (Doing a Deal — Financial Structures)

"Debt 'eats' before equity, senior debt eats before subordinated debt, and preferred equity eats before common equity." — Brent Beshore, (Doing a Deal — Financial Structures)

"Beware of the headline number. The devil is in the details." — Brent Beshore, (Doing a Deal — Financial Structures, "Math, Explained")

"You set the price and I'll set the terms." — Brent Beshore, (Doing a Deal — Financial Structures)

"It's crucial to understand how the debt is stacked." — Brent Beshore, (Doing a Deal — Financial Structures)

Rules of Thumb

• Never compare offers by headline price. Decompose every offer into amount, timing, probability of cash before ranking them.
• Read the cap table and the waterfall before you sign: liquidation preferences and preferred returns are rarely disclosed and silently consume proceeds before common is reached.
• Use SDE for small owner-operated firms (it adds back owner pay); use EBITDA / EBIT / owner earnings / DCF as the business grows and the owner becomes less central.
• Normalization is the lever: add back one-time costs and strip one-time revenue, because the multiple amplifies every dollar of the base. But aim for "an accurate representation of the business's true earning power," not a distorted one.
• Treat rolled equity and the seller note as the most subordinated dollars you own — their value is set by how aggressively the buyer levers, which is why buyer character ≥ checkbook.
• Remember price is tied to adjusted TTM across a 6–18 month close; you carry performance risk the whole way.

Related References

• Deal Terms & Risk Allocation - terms that allocate risk
• Types of Buyers & Closing Certainty - how each buyer funds the deal
• Deal Vocabulary Glossary - definitions

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