This gets a little wonky but is important for those doing PE investing or acquiring SMBs. One area of accounting that I have seen botched many times is the accounting for non-consolidated related entities. 1/x

Let's assume we're investing in two entities: Entity 1 and Entity 2. Entity 1 is the original entity and ownership started Entity 2 for some compliance reasons. Entity 1 manufactures a product, sells through to Entity 2, and Entity 2 sells on to its end customers. 2/x

Entity 1 does $3 million of TTM EBITDA standalone and Entity 2 does $2 million. Combining EBITDA of the two entities gets us $5 million. Boom diligence is done... NOT so fast. 3/x

Entity 2 has not sold all of its purchases it has made from Entity 1. Let's assume inventory over the trailing 12 months for Entity 2 increased $2 million. If Entity 1 earns 50% gross margins, there are $1 million of Entity 1's margins capitalized on Entity 2's balance sheet. 4/x

Therefore, the combined TTM EBITDA of the entities is really $4 million - $3 million Entity 1 (PLUS) $2 million Entity 2 (MINUS) $1 million of Entity 1 margins capitalized into Entity 2's balance sheet. 5/x

This is because Entity 1 is recognizing revenue for costs that Entity 2 has capitalized.

Therefore, don't get duped when investing in or lending to non-consolidated related party entities. 6/6