Walking away in week two on a single number

The situation

An independent sponsor had a signed indication of interest on a manufacturing business: $1.2 million of trailing EBITDA, an asking price of $7.2 million, a 6.0x multiple that looked defensible against comparable transactions the sponsor had seen. Before committing to a quality-of-earnings review, legal diligence, or any other diligence spend, the sponsor ran the deal through its own quick financing screen.

The problem

At $1.2 million of trailing EBITDA — above the rough $1 million line — the deal sits on the EBITDA side of the underwriting basis lenders typically apply — smaller deals get measured on seller’s discretionary earnings, but, as deavo’s financing guidance notes, lenders shift the underwriting basis “from roughly $1M up” to EBITDA. The same guidance states a target debt service coverage ratio of “≥ 1.30× on EBITDA,” carrying the disclaimer that the figures are “illustrative estimate only — not a financing offer, pre-approval, or financial, legal or investment advice. Actual structures, rates and terms are set by a lender after reviewing the real business.”

The numbers

The sponsor’s proposed structure funded 65% of the $7.2 million price with senior debt — $4,680,000 — on a 6-year term at an indicative 8.0% annualized rate. Amortizing that facility produces annual debt service of approximately $984,700. Against $1,200,000 of trailing EBITDA, that is a debt service coverage ratio of 1.22× — below the 1.30× EBITDA-basis band the sponsor uses as its own screening threshold, and below what the sponsor expected a lender to require before underwriting the facility.

The rule that decided it

A debt service coverage ratio is a single number for a reason: it tests whether the cash the business actually generates can service the debt being proposed against it, independent of how attractive the multiple looks or how clean the target’s books turn out to be. A deal that fails its own DSCR screen at the structure the buyer intends to use is not financeable as proposed, and no amount of diligence on the target’s operations changes that math — only a lower price, a smaller debt component, or a longer amortization does.

The outcome

Before withdrawing, the sponsor ran the reverse calculation: at the same 65% leverage, 6-year term and 8.0% rate, what price would actually clear the 1.30× threshold? Holding debt service to $923,077 a year — the level $1.2 million of EBITDA can service at 1.30× — caps the financeable senior debt at roughly $4,387,000. At the same 65% leverage ratio, that implies a total price of about $6,750,000, a 5.6× multiple, roughly $450,000 below the seller’s $7.2 million ask. The sponsor took that specific number back to the seller as a counter, rather than a vague request for “a lower price.”

The seller was not willing to move that far, and the sponsor was not willing to fund the gap with additional equity at the original valuation. The sponsor withdrew in week two, having spent screening time, not diligence fees, on a deal that was never going to close as structured — and having given the seller a specific, financeable number to reconsider if no other buyer met the original ask either.

The same discipline — testing a headline number before trusting it — is what caught a distorted gross margin in the rebate cheque that inflated gross margin. For how a teaser’s own specificity can end a process even earlier, see a teaser that gave away the vendor’s identity.

What it would have cost otherwise

Skipping the quick screen and proceeding straight to diligence would have cost several weeks of legal and accounting fees on a quality-of-earnings review and a lawyer-drafted purchase agreement, all in service of a deal that could not close on the buyer’s own financing terms — fees typically running well into five figures before a single financing conversation with an actual lender confirmed what the back-of-envelope math already showed.

The tell

The tell is a multiple that looks reasonable in isolation without ever being run against the buyer’s actual proposed financing structure. A 6.0x multiple is unremarkable on its face; whether it is financeable depends entirely on the debt percentage, the rate, and the amortization a lender will actually offer — three inputs that take minutes to model and that a sponsor should run before, not after, committing diligence budget.

Takeaways

• • Run a debt service coverage ratio screen against your own proposed financing structure before spending on diligence, not after.
• • Above roughly $1M of EBITDA, lenders typically underwrite on an EBITDA basis rather than seller’s discretionary earnings — know which basis applies to your deal.
• • A DSCR below the lending target is a structural problem, not a diligence finding — only price, leverage, or amortization can fix it.
• • Reproduce any illustrative financing benchmark with its disclaimer — actual lender terms are set only after the lender reviews the real business.

Sources

• • No statute or regulator sets a DSCR threshold — debt service coverage is lender credit policy, not law. No Canadian statute, regulation or OSFI guideline prescribes a minimum coverage ratio for a private acquisition loan, which is why this file’s 1.30× is described throughout as the sponsor’s own screen and an illustrative market benchmark — never as a legal requirement.
• • Deavo — Financing (illustrative benchmark tool, not a lender) — the source of the two benchmarks quoted: “≥ 1.30× on EBITDA” as a coverage target, and the basis switch — main-street deals measured on SDE, but “from roughly $1M up, lenders switch to EBITDA.” Carries its own disclaimer, reproduced in the file: “Illustrative estimate only — not a financing offer, pre-approval, or financial, legal or investment advice.” It is a commercial modelling tool, not a regulator or a lender commitment, and should never be cited as either.
• • Treadstone Law — Loan covenants in Ontario acquisition financing — on point for what a failed coverage ratio does after closing rather than before it: it describes “debt service coverage — a measure of whether the business’s cash flow comfortably covers its loan payments” as a financial covenant, and explains that a covenant breach is an event of default independent of payment status, so a lender may accelerate or enforce even where every payment has been made on time. That is the downstream cost of financing a deal that only just clears the screen.