EBITDA and SDE Explained
Working as a corporate attorney and merger and acquisitions advisor, I realize the world of M&A can be murky at times. Often, clients sort of just find themselves in the M&A process and have trouble making sense of the overwhelming landscape of buying and selling a business. Today, I’m going to attempt to clear up a set of commonly used acronyms you’ll see when valuing a business for sale. Those are EBITDA and SDE.
What is EBITDA?
Seller Discretionary Earnings (SDE) is almost exclusively an M&A term. EBITDA shows up in other contexts; it shows up in finance and things like that, but a really important term in the M&A context. EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. So, it’s the net earnings of a business, adding back in the interest the business paid on loans, the taxes the business paid, the depreciation that reduced its income – the depreciation to assets is an accounting calculation that reduces earnings – and then amortization, which is similar to depreciation.
Depreciation is calculated against hard assets, so if you buy a huge piece of equipment for your business, you might depreciate it over time. You write that off and reduce your earnings because the asset is losing value over time – it could be a couple years, could be 15 years. Amortization is on intangible assets like goodwill and other things like that.
How is EBITDA Calculated?
So, we add all these things back in. If a business makes $1,000,000 in net earnings, but they had $100,000 in paid interest, they pay $200,000 in taxes – that’s $300,000 – and then they had $100,000 of depreciation and amortization, we add that back in with total add backs of $400,000 calculating an EBITDA of $1.4 million.
What is SDE?
Seller Discretionary Earnings (other words you might hear for it are recast earnings or owners benefit or adjusted earnings) is a similar idea, but it doesn’t show up in finance. SDE shows up in mergers and acquisitions or just business brokerage in the Main Street part of the market, which I define as businesses that are trading hands for less than $2 million.
SDE is similar to EBITDA in that we’re adding certain things back in when recasting the business’s financials, but we’re dealing with different line items in a smaller business than in larger operations. We’re adding back in the compensation of the owner-operators. In small businesses, owners tend to take money out of their business in a lot of different ways. Some will pay themselves some salary while others will have distributions – there are all sorts of things going on – and we’re adding that back in because the idea is that how the owner/operator pays themselves can be wildly different in small businesses. Some take hardly anything out, they’re building everything up in terms of building the worth of their business. Some suck it all out every year.
So, we’re trying to sort of normalize for unique decisions of different owners, and then we add back in discretionary expenses – things that an owner might run through the business that are defensible deductions as a business expense that aren’t really necessary – certain travel, entertainments, professional dues, research periodicals, home office, stuff like that. Expenses like those aren’t necessary to run the business under a new owner.
One-time expenses are also often added back in. An example might be a one-off litigation matter that’s not going to happen again.
What’s the Purpose of EBITDA and SDE?
So, that’s what these things are, EBITDA and SDE. Why do they exist? They exist so that so that people looking at the business from an investment or a purchase standpoint can compare apples and apples – one business to another. So, there could be two exactly similar businesses; I mean exactly the same – same revenue, same industry, same type of customer, same net earnings, but one business is highly levered that has tons and tons of loans and the other business has none. Well, the net earnings of the one with a lot of loans is going to be much less than the other business, but, from a buyer’s perspective, that’s the same business. And, that’s because most buyers are going to require all the debt be paid off at closing, so, in the hands of the new buyer, those are identical businesses. They’re not the same in the hands of the sellers, but we’re trying to normalize – we’re trying to get an apples to apples comparison.
With SDE, we add back those one-time charges because we’re trying to give the buyer a normalized view of what the business will produce for them next year. In doing so, keep in mind that is has to be defensible. If, for example, there is some reason these one-time charges have a pattern of popping up every so often, a buyer may see that in the historical profit and loss statements and the add back would raise a red flag. Again, when comparing these two businesses, we add back in the owners’ salaries because those two businesses are exactly the same, but one owner is letting a lot of money build up and the other is taking it all out. What do a buyer care? I mean they both truly produce the same amount of amount of SDE.
Still Have Questions?
So, that’s why we use these metric in the industry – to normalize the financials of businesses. If you have questions about EDBITDA or SDE or anything about mergers and acquisitions, contact me.