The Difference Between SDE and EBITDA

by

Michael Fekkes

The 3 most commonly used valuation methods are the Income, Market, & Asset approach. With the income approach, a business value is based upon the earnings the enterprise generates. Buyers are most concerned with the amount of earnings that the company produces should they acquire the business. The net ordinary income, utilized for tax reporting purposes, does not properly reflect the true earnings of the company based on the non-cash, discretionary & non-recurring items that are expensed by the business owner. Earnings are kept low to achieve the goal of reducing taxes. Therefore, to calculate the true earning capacity of the company, the P&L statements need to be adjusted during a valuation to determine SDE or EBITDA. Re-casting the financial statements will standardize (or normalize) the company earnings through the exclusion of discretionary, variable and non-recurring components, allowing an objective comparison to be made between two or more companies. By applying a multiple to the EBITDA or SDE amount, consistent with the industry sector and a weighting of the issues affecting the business, will derive the business value.

What is Sellers Discretionary Earnings (SDE)?

Sellers Discretionary Earnings is utilized for businesses with under $1mm in adjusted earnings. These businesses often have the owner managing the company and receiving a salary. With these small enterprises it is critical to determine what the owner benefit is as opposed to the earnings of the company. This is accomplished through a series of profit and loss statement adjustments termed add-backs that are made to the pre-tax company earnings. In some instances, there are negative add-backs as in the case with a business that owns real property (e.g. the building & land) where the owner is compensating himself a below market rent or a family employee working for the company who is receiving a below market salary. In both of these cases, an adjustment is made to normalize the expense to the current market value.

The most common adjustments used during the re-casting process are:

1. Add-back one owner’s total compensation

a. Salary

b. Payroll Taxes

c. Retirement Contributions e.g. 401K

d. Insurance

e. Perks (Health Club, etc)

2. Add-back interest expense

3. Add-back discretionary expenses

a. Donations

b. Personal Cell Phones

c. Travel, Meals, & Entertainment

d. Owners Vehicles (not used in business)

4. Add-back non-cash expenses

a. Depreciation

b. Amortization

5. Add-back Non-recurring expenses

a. Fines / Bank Penalties

b. Attorney fees (e.g. sale of business consultation)

6. Adjust Lease to Fair Market Value

What is Earnings Before Interest Taxes Depreciation Amortization (EBITDA)?

EBITDA is used to define the earnings of the company for businesses with adjusted income greater than $1mm. Here, the owner/investor is typically not active in the direction or daily management of the business and will hire a general manager to perform that function. Therefore, the EBITDA calculation will differ from SDE as it incorporates the general managers salary in the earnings calculation as an expense. EBITDA is a non-GAAP measure that is used to determine profitability and to make comparisons between companies and industries as it eliminates the impact of the financing and accounting decisions made. An easy way to determine EBITDA is to subtract the owners compensation and benefits from SDE. The EBITDA dollar amount will be lower than SDE but the multiple used in the valuation formula will be higher, often 2-2.5 times the SDE multiple. Therefore, as one would anticipate the FMV of the same business calculated using either method should be very close to each other. If not, an assessment as to why and which (or what other method(s)) must be undertaken.

Michael Fekkes is a Senior Broker at ENLIGN Business Brokers. Michael is a Certified Business Intermediary (CBI), a member of the International Business Brokers Association (IBBA), as well as a former business owner. ENLIGN Business Brokers http://www.enlign.com/ is a Professional Services Firm that is headquartered in Raleigh, NC providing confidential business intermediary services to buyers and sellers throughout the Southeast region.

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