The EBITDA Mirage: How to Calculate True Earnings in Services Acquisitions

The Multiplier Trap: Why You're About to Overpay

You know the math. At a 9.4x EBITDA multiple—the rebounding average for lower middle-market deals in Q3 2025—every $100,000 in missed expenses inflates the purchase price by nearly $1 million. Yet, in the rush to deploy capital before year-end, Private Equity sponsors consistently accept "Adjusted EBITDA" schedules that are little more than creative fiction.

For services businesses—consultancies, MSPs, digital agencies—the risk is exponentially higher than in manufacturing or SaaS. There is no machinery to appraise. There is no IP to patent. The asset is the people and the process. When a founder presents you with a $5M EBITDA business, they are typically showing you a cash-basis fantasy where they underpay themselves, ignore the cost of their own tribal knowledge, and capitalize software development that should be expensed.

We call this the EBITDA Mirage. The financial due diligence (FDD) team will catch the obvious personal expenses—the country club dues and the leased Range Rover. But they will miss the operational debt that hits your P&L on Day 101. If you are buying a founder-led services firm in 2025, the standard Quality of Earnings (QoE) report is insufficient. You need to calculate Adjusted EBITDA through an operational lens, or you will begin your hold period with a margin contraction that no amount of value creation can fix.

The 2025 Adjusted EBITDA Methodology: Beyond the QoE

To arrive at a defensible number, you must layer Operational Normalization on top of standard Financial Normalization. Here is the diagnostic framework we use to strip away the mirage.

1. The "Replacement Cost" Reality Check

The most common and dangerous add-back is Owner Compensation. A founder pays themselves $150,000 and adds back nothing, claiming this is market rate. It isn't. In 2025, the replacement cost for a non-founder CEO in a $20M-$50M services firm is $500,000 to $625,000 (total comp). Furthermore, that founder is likely doing the work of three people: CEO, VP of Sales, and Lead Architect.

• The Adjustment: You must model the cost of three hires, not one. If the founder exits, you aren't just replacing a head; you are replacing a workflow. This is the key person risk that kills post-close margins. Deduct the full market burden of the executive team you will need to hire, not the team that exists today.

2. Revenue Quality and The "Phantom Backlog"

In services, revenue recognition is fluid. Founders often book revenue when the invoice is sent, not when the work is delivered (or vice versa, depending on what boosts EBITDA that quarter). In 2025, we are seeing a rise in "Phantom Backlog"—deals signed but stalled due to lack of delivery capacity.

• The Adjustment: Audit the Revenue Quality by matching recognized revenue to timesheets and delivery milestones, not invoices. If 20% of the "revenue" is from fixed-price projects that are 50% over budget, that is not revenue; it is a liability. You must accrue for the cost to complete these bad contracts and deduct it from EBITDA.

3. The Tribal Knowledge Tax

Financial auditors look at what was spent. Operational diligence looks at what should have been spent. A firm running on tribal knowledge has artificially high margins because they haven't invested in documentation, training, or systems. They rely on "heroics" to deliver.

• The Adjustment: Calculate the "Documentation Deficit." If the firm has no SOPs, you will need to spend $250k-$500k in the first year to build them or face massive attrition. While this is technically a one-time cost, the inefficiency of operating without them is a recurring drag. We typically normalize EBITDA down by 3-5% for firms with low process maturity to account for the inevitable productivity dip during professionalization.

The Operator's Verdict: Bridge the Gap or Kill the Deal

Once you have calculated the Operational Adjusted EBITDA, the result is often shocking. That $5M EBITDA business is frequently a $3.2M EBITDA business with a heavy earnout liability. This doesn't mean you shouldn't buy it. It means you shouldn't pay 9.4x for it.

The 5-Day Stress Test

Before you sign the LOI or move to exclusivity, perform this 5-day stress test:

1. Re-slicing the P&L: Ask for the P&L by project or customer, not just by GL code. If they can't produce it, assume their margins are blended and hide unprofitable accounts.
2. The "Bus Factor" Audit: Identify the top 5 revenue-generating employees. Calculate the impact if two of them leave post-close. If that erases >20% of EBITDA, your valuation risk is critical.
3. Technical Debt Quant: For tech-enabled services, quantify the technical debt. Is their proprietary platform a value driver or a maintenance nightmare waiting to explode?

Your job as an Operating Partner is not to accept the CIM's numbers but to pressure-test the engine that produces them. Real EBITDA is not what's left over after expenses; it's the cash flow generated by a system that can survive the founder's exit. If the system doesn't exist, neither does the EBITDA.