Finance & Budgeting Free · self-study ~60 min

Negotiating EBITDA Adjustments in M&A Due Diligence

Alex Vance reviews Caldmere Systems's financial data and raises concerns about revenue sustainability, inventory valuation, and maintenance costs during acquisition talks. Sam Brooks defends the figures and proposes working-capital and EBITDA adjustments to address Alex's due diligence queries.

 Level

What you’ll be able to do

Dialogue

Beginner version

Alex Vance
Thank you for meeting me, Sam Brooks. I looked at the files about Caldmere Systems for Q3. The money they made looks good. But we need to check if this growth is good before we finish the deal.
Sam Brooks
Yes, Alex Vance. Thank you for checking. The growth is real. It comes from long deals with big London production houses. I know you worry about these deals after you buy the company.
Alex Vance
That is my worry. If the deals are not good, we will pay less. We need to check if clients stay with them. We need to see if they have steady money, not just one-time projects.
Sam Brooks
I see your point. The data shows 92% of clients stay if their contract is over six months. If this stays true, the EBITDA supports the price. We checked the invoices for the last two years to show this is stable.
Alex Vance
The renewal rate is good. But let's look at the working capital. Caldmere Systems has a lot of stock in special LED lights. If we change the working capital target, we will pay more cash at the end.
Sam Brooks
That is fair. They have more stock than normal because they keep old lights for period dramas. But the value is low. We can talk about changing the working capital to protect both sides.
Alex Vance
I agree we need to fix the numbers. Also, look at the cost to fix their fleet. AV equipment breaks fast with heavy use. If the EBITDA does not include this cost, our profit will drop in the first eighteen months.
Sam Brooks
We already separated the maintenance costs in the add-back schedule. You will see a line for fixing lights. This makes the EBITDA show true performance, not hidden costs.
Alex Vance
Noted. Let's talk about the earn-out. The sellers want a bonus based on first-year revenue. But mixing their logistics with our Korveth Partners division takes time. We cannot promise quick results.
Sam Brooks
I understand the risk. Maybe we can base the earn-out on EBITDA instead of revenue. This matches the incentives with profit and efficiency, which are important for your division.
Alex Vance
That is a good idea. But we must also think about regional agencies. Caldmere Systems has good contacts in Westbrook. We are strong in Eastgate and Hillcrest. We need to make sure their clients do not clash with ours.
Sam Brooks
There is little overlap. Caldmere Systems does high-end boutique lighting. Your agencies do broader AV production. Combining their lights with your staging could be great for international shoots in London.
Alex Vance
That is an interesting point. If we bundle their lighting with our production management, we can sell more to existing clients. But this needs their technical teams to stay. Have you checked if they might leave?
Sam Brooks
Yes. We found three key technical directors who keep clients happy. We propose bonuses for them when the deal closes. This reduces the risk of problems during the change.
Alex Vance
I appreciate that. Losing them would ruin the deal. Let's go back to the financial model. The savings from moving their warehouse to our Brookside seem too high. London real estate prices change a lot.
Sam Brooks
The savings come from a slow move. We will use their warehouse for six months while we fix the logistics. This reduces risk and lets us check the savings before moving everything.
Alex Vance
A slow move is smart. It lets us watch the integration. One last point: the software they use to control lights. Do they own it, or do they pay for licenses?
Sam Brooks
They own the software. It is made in-house. There are no fees to use it. This is a big asset because it allows custom lights for your production platform.
Alex Vance
That adds value. It fits our goal to digitize workflows. I think we are making progress. I will share this with my finance team to fix the valuation model.
Sam Brooks
Good. I will add the maintenance cost details and the retention bonuses to the data room. Let's meet next week to discuss the new term sheet.
Alex Vance
Agreed. Thank you for the good talk, Sam Brooks. I look forward to finishing this deal and growing in London.
Sam Brooks
Me too, Alex Vance. It was good working on this. I am sure we can make a good deal.

Intermediate version

Alex Vance
Thanks for meeting with me, Sam Brooks. I’ve gone through the initial files on Caldmere Systems’s Q3 results. The revenue looks strong, but we need to make sure the growth is solid before we lock in the term sheet.
Sam Brooks
Absolutely, Alex Vance. I appreciate your attention to detail. The growth is genuine, mostly from long-term deals with big London production houses. I get your worry about whether these contracts will hold up after the acquisition.
Alex Vance
That’s exactly my concern. If the backlog isn’t as sticky as it seems, we’d have to lower the EBITDA multiple. We need to check client retention rates to ensure these are steady income streams, not just one-off projects.
Sam Brooks
I see your point. The data shows a 92% renewal rate for clients with contracts over six months. If this trend continues, the EBITDA should support the current valuation. We’ve audited the last two years of invoices to prove this stability.
Alex Vance
The renewal rate is good, but let’s look at working capital. Caldmere Systems has a lot of inventory tied up in specialized LED fixtures. If we adjust the working capital target based on actual inventory days, the purchase price would mean more cash out for us at closing.
Sam Brooks
That’s a fair point. Inventory is higher than average because they stock niche heritage lighting for period dramas. But if you check the depreciation schedule, the net book value is conservative. We’re open to negotiating a working capital adjustment to protect both sides.
Alex Vance
I agree a normalization adjustment is needed. Another issue is maintenance costs for their fleet. Audiovisual equipment wears out fast with heavy rental use. If maintenance capex isn’t fully included in the EBITDA, our margins could take a hit in the first eighteen months.
Sam Brooks
We’ve already separated the maintenance costs in the add-back schedule. You’ll see a specific line for preventive maintenance and refurbishment. This ensures the EBITDA reflects true operations, not deferred maintenance.
Alex Vance
Noted. Let’s talk about the earn-out. The sellers want a performance-based earn-out linked to first-year revenue retention. From a production leadership view, integrating their logistics with our Korveth Partners division will take time. We can’t promise immediate synergy.
Sam Brooks
I understand the integration risk. Maybe we could base the earn-out on EBITDA contribution instead of gross revenue. This would align incentives with profitability and efficiency, which are key for your division.
Alex Vance
That’s a reasonable compromise. But we also need to consider regional agency management. Caldmere Systems has strong ties in Westbrook, but our strength is in Eastgate and Hillcrest. We need to make sure their client base doesn’t clash with our existing agencies.
Sam Brooks
There’s minimal overlap. Caldmere Systems focuses on high-end boutique lighting, while your agencies handle broader audiovisual production. Combining their lighting inventory with your staging could actually create a unique value for international productions shooting in London.
Alex Vance
That’s an interesting angle. If we bundle their lighting services with our production management, we could upsell to existing clients. But this depends on a smooth transfer of their technical teams. Have you checked the key person risk?
Sam Brooks
Yes, we’ve identified three key technical directors who are crucial for client relationships. We’re proposing retention bonuses for them as part of the closing conditions. This should reduce the risk of disruption during the transition.
Alex Vance
I appreciate that foresight. Losing those experts would undermine the whole acquisition. Let’s go back to the financial model. The projected savings from consolidating their warehouse with our Brookside seem optimistic. London real estate costs are volatile.
Sam Brooks
The savings are based on a phased consolidation. We plan to use their existing warehouse for the first six months while we optimize logistics. This reduces immediate disruption risk and lets us verify cost savings before committing to a full move.
Alex Vance
A phased approach is wise. It lets us monitor integration closely. One last point: the intellectual property for their proprietary lighting control software. Is it fully owned by Caldmere Systems, or are there licensing dependencies?
Sam Brooks
The software is entirely in-house developed and owned. There are no third-party licensing fees. This is a significant asset, as it allows for customized lighting solutions that can be integrated into your production management platform.
Alex Vance
That adds substantial strategic value. It aligns well with our goal of digitalizing production workflows. I think we’re making progress. I’ll share these points with my finance team to refine the valuation model.
Sam Brooks
Great. I’ll update the data room with the detailed maintenance cost breakdown and the key person retention proposals. Let’s aim to reconvene next week to discuss the revised term sheet.
Alex Vance
Agreed. Thanks for the productive discussion, Sam Brooks. I look forward to finalizing this deal and expanding our footprint in the London market.
Sam Brooks
Likewise, Alex Vance. It’s been a pleasure working through these details. I’m confident we can reach a mutually beneficial agreement.

Advanced version

Alex Vance
Thank you for joining me, Sam Brooks. I’ve reviewed the preliminary data room files regarding Caldmere Systems’s Q3 performance. While the revenue figures look robust, we need to align on the quality of that growth before we finalize the term sheet.
Sam Brooks
Absolutely, Alex Vance. I appreciate your thoroughness. The growth is real, driven largely by long-term framework agreements with major London production houses. However, I understand your caution regarding the sustainability of these contracts post-acquisition.
Alex Vance
That is precisely my concern. We would be inclined to adjust the EBITDA multiple if the contracted backlog proves to be less sticky than presented. Subject to verification of the client retention rates, we need to ensure these are not one-off project spikes but recurring revenue streams.
Sam Brooks
I see your point. The data shows a 92% renewal rate for clients with contracts exceeding six months. On the assumption that this trend holds, the run-rate EBITDA should support the current valuation. We have audited the last two years of invoices to confirm this stability.
Alex Vance
The renewal rate is encouraging, but let’s look at the working capital. Caldmere Systems has significant inventory tied up in specialized LED fixtures. If we were to revise the working-capital target based on actual days inventory outstanding, the purchase price would reflect a higher cash outlay for us at closing.
Sam Brooks
That is a fair observation. The inventory levels are higher than industry average because they stock niche heritage lighting for period dramas. However, had the numbers been verified against the current depreciation schedule, you would see that the net book value is conservative. We are prepared to negotiate a working-capital adjustment mechanism to protect both parties.
Alex Vance
I agree that a normalization adjustment is necessary. Another point is the maintenance cost of their fleet. Audiovisual equipment degrades quickly under heavy rental use. If the maintenance capex is not fully accrued in the EBITDA calculation, our projected margins could be squeezed significantly in the first eighteen months.
Sam Brooks
We have already isolated the maintenance costs in the add-back schedule. You will notice a specific line item for preventive maintenance and fixture refurbishment. This ensures that the EBITDA figure reflects true operating performance, not deferred maintenance.
Alex Vance
Noted. Let’s discuss the earn-out structure. The sellers are proposing a performance-based earn-out linked to the first year’s revenue retention. From a production leadership perspective, integrating their logistics network with our Korveth Partners division will take time. We cannot guarantee immediate synergy realization.
Sam Brooks
I understand the integration risk. Perhaps we could structure the earn-out around EBITDA contribution rather than gross revenue. This would align the incentives with profitability and operational efficiency, which are key metrics for your division.
Alex Vance
That is a reasonable compromise. However, we must also consider the regional agency management aspect. Caldmere Systems has strong relationships in the Westbrook, but our strength lies in the Eastgate and broader Hillcrest market. We need to ensure their client base doesn’t overlap negatively with our existing regional agencies.
Sam Brooks
There is minimal overlap. Caldmere Systems focuses on high-end boutique lighting, while your regional agencies handle broader audiovisual production. In fact, combining their lighting inventory with your staging capabilities could create a unique value proposition for international productions shooting in London.
Alex Vance
That is an interesting angle. If we were to bundle their lighting services with our production management, we could potentially upsell to existing clients. But this relies on the seamless transfer of their technical teams. Have you assessed the key person risk?
Sam Brooks
Yes, we have identified three key technical directors who are critical to maintaining client relationships. We are proposing retention bonuses for them as part of the closing conditions. This should mitigate the risk of operational disruption during the transition.
Alex Vance
I appreciate that foresight. Losing those experts would undermine the entire acquisition rationale. Let’s return to the financial model. The projected cost savings from consolidating their warehouse operations with our Brookside seem optimistic. Real estate costs in London are volatile.
Sam Brooks
The savings are based on a phased consolidation. We plan to utilize their existing warehouse for the first six months while we optimize the logistics flow. This reduces the immediate risk of disruption and allows us to verify the cost-saving assumptions before committing to a full move.
Alex Vance
A phased approach is prudent. It allows us to monitor the integration closely. One final point: the intellectual property regarding their proprietary lighting control software. Is it fully owned by Caldmere Systems, or are there licensing dependencies?
Sam Brooks
The software is entirely in-house developed and owned. There are no third-party licensing fees associated with it. This is a significant asset, as it allows for customized lighting solutions that can be integrated into your production management platform.
Alex Vance
That represents a significant strategic asset. It dovetails perfectly with our initiative to digitize production workflows. I believe we are advancing effectively. I will circulate these insights to my finance team for a more precise valuation model.
Sam Brooks
Excellent. I will update the data room with the detailed maintenance cost breakdown and the key person retention proposals. Let’s aim to reconvene next week to discuss the revised term sheet.
Alex Vance
Understood. I appreciate the constructive dialogue, Sam Brooks. I am eager to conclude this transaction and broaden our presence in the London market.
Sam Brooks
Likewise, Alex Vance. It has been a pleasure working through these details. I am confident we can reach a mutually beneficial agreement.

Check your understanding

1. What is Alex Vance's primary concern regarding Caldmere Systems's growth as mentioned in the dialogue?

Show answer
Alex Vance is concerned about the sustainability of the growth and whether the contracted backlog is 'sticky' or if it consists of one-off project spikes rather than recurring revenue streams.

2. According to Sam Brooks, what is the client renewal rate for clients with contracts exceeding six months?

Show answer
The data shows a 92% renewal rate for clients with contracts exceeding six months.

3. Why does Alex Vance believe the purchase price might need to reflect a higher cash outlay at closing?

Show answer
Alex Vance notes that Caldmere Systems has significant inventory tied up in specialized LED fixtures, and revising the working-capital target based on actual days inventory outstanding would increase the cash outlay.

4. How does Sam Brooks justify the higher inventory levels compared to the industry average?

Show answer
Sam Brooks explains that the higher inventory levels are because Caldmere Systems stocks niche heritage lighting specifically for period dramas.

5. What adjustment does Sam Brooks propose to address Alex Vance's concern about maintenance costs squeezing projected margins?

Show answer
Sam Brooks states that maintenance costs have been isolated in the add-back schedule, with a specific line item for preventive maintenance and fixture refurbishment to ensure EBITDA reflects true operating performance.

6. What is the nature of the overlap between Caldmere Systems and Alex Vance's existing regional agencies?

Show answer
There is minimal overlap because Caldmere Systems focuses on high-end boutique lighting, while the regional agencies handle broader audiovisual production.

Grammar practice (mixed)

Adjectives and Adverbs

Caldmere Systems has ____ inventory levels tied up in specialized LED fixtures.

Show answer & why
significant · 💡 The blank modifies the noun 'inventory levels', requiring an adjective to describe the extent or size of the inventory.
Prepositionsself-check

The growth is real, driven largely ____ long-term framework agreements with major London production houses.

Show answer & why
by · 💡 The passive construction 'driven by' indicates the agent or cause of the growth. In business contexts, 'driven by' is the standard collocation for identifying the source of a trend.
Prepositionsself-check

If we were to revise the working-capital target based ____ actual days inventory outstanding, the purchase price would reflect a higher cash outlay.

Show answer & why
on · 💡 'Based on' is the fixed prepositional phrase used to indicate the foundation or evidence for a calculation or decision in business analysis.
Conjunctions

Sam Brooks: I see your point. The data shows a 92% renewal rate for clients with contracts exceeding six months. ____ this trend holds, the run-rate EBITDA should support the current valuation.

Show answer & why
On the assumption that · 💡 'On the assumption that' introduces a conditional clause based on a supposition, which fits the context of projecting future performance based on current data.
Tensesself-check

While the revenue figures look robust, we need to align on the quality of that growth before we finalize the term sheet. The team has been analyzing the data for weeks, but they haven't ____ the final report yet.

Show answer & why
completed · 💡 The present perfect tense 'has been analyzing' indicates an ongoing action leading up to the present, and 'haven't' requires the past participle 'completed' to form the present perfect negative.
Prepositionsself-check

The growth is driven largely ____ long-term framework agreements with major London production houses.

Show answer & why
by · 💡 The passive voice 'is driven' is typically followed by the preposition 'by' to introduce the agent or cause of the action.
Conjunctionsself-check

____ the contracted backlog proves to be less sticky than presented, we would be inclined to adjust the EBITDA multiple.

Show answer & why
If · 💡 The sentence describes a hypothetical situation and its potential consequence, which requires the conditional conjunction 'If' to introduce the condition.

Discussion (practise speaking)

How do you balance the need for thorough due diligence with the pressure to close a deal quickly?

🤔 Think about a time when you had to balance speed and accuracy in a project.

Show sample answer
  • Prioritizing high-risk areas like client retention over minor details.
  • Communicating clearly with stakeholders about potential delays.
  • Using phased approaches to manage integration risks effectively.

Ask Phil: Practise discussing due diligence trade-offs with the Pickle AI tutor.

What strategies can you use to mitigate key person risk during an acquisition?

🤔 Consider how you would handle the loss of a key team member in your current role.

Show sample answer
  • Implementing retention bonuses for critical staff.
  • Documenting processes to reduce dependency on individuals.
  • Creating a succession plan for key roles.

Ask Phil: Practise strategies for managing key person risk with the Pickle AI tutor.

How can you ensure that projected cost savings from consolidation are realistic?

🤔 Reflect on a time when cost-saving projections were not met in your work.

Show sample answer
  • Conducting a detailed audit of current costs and processes.
  • Phasing the consolidation to test assumptions before full implementation.
  • Monitoring real-time data to adjust plans as needed.

Ask Phil: Practise evaluating cost-saving strategies with the Pickle AI tutor.

What factors should be considered when structuring an earn-out to align incentives?

🤔 Think about how you would structure a performance-based agreement in your industry.

Show sample answer
  • Linking payments to measurable performance metrics like EBITDA.
  • Ensuring the metrics are achievable and relevant to both parties.
  • Including clear definitions and timelines to avoid disputes.

Ask Phil: Practise designing earn-out structures with the Pickle AI tutor.

Vocabulary

term sheet
reveal definition A document outlining the key terms of a proposed business deal. “While the revenue figures look robust, we need to align on the quality of that growth before we finalize the term sheet.”
↗
data room
reveal definition A secure digital space for sharing confidential business documents. “I’ve reviewed the preliminary data room files regarding Caldmere Systems’s Q3 performance.”
↗
framework agreements
reveal definition Long-term contracts that set the terms for future transactions. “The growth is real, driven largely by long-term framework agreements with major London production houses.”
↗
client retention rates
reveal definition The percentage of customers who continue to use a service over time. “Subject to verification of the client retention rates, we need to ensure these are not one-off project spikes but recurring revenue streams.”
↗
working capital
reveal definition The money available for a company to cover its short-term operational costs. “Let’s look at the working capital. Caldmere Systems has significant inventory tied up in specialized LED fixtures.”
↗
earn-out structure
reveal definition A payment arrangement where part of the purchase price depends on future performance. “Let’s discuss the earn-out structure. The sellers are proposing a performance-based earn-out linked to the first year’s revenue retention.”
↗
key person risk
reveal definition The danger that a business will suffer if a crucial employee leaves. “But this relies on the seamless transfer of their technical teams. Have you assessed the key person risk?”
↗

Key phrases (useful expressions from the dialogue)

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