What is EBITDA and SDE?
EBITDA and SDE are important concepts to understand when considering the process of acquiring and selling companies. They are metrics that will provide insight into the value of a company, allowing you to make a knowledgeable decision. In this article, I will outline the components, give a brief example and explain the importance of these metrics.
First, when you’re getting initiated to the small and medium sized business (SMB) space, you’re going to hear a term called EBITDA pretty frequently. EBITDA stands for “earnings before interest taxes, depreciation, and amortization”. It’s essentially trying to get an earnings amount that can be compared across different businesses.
EBITDA is certainly not perfect by any means. There’s plenty of complaints about EBITDA, but it is likely the most popular metrics cited in the business universe. EBITDA will especially come into play with acquisitions.
Now, when we get into the small business or the lower middle market, there’s another term that is similar to EBITDA. It’s called SDE and that is the seller’s discretionary earnings. SDE is a popular term because what you’re doing is you’re taking EBITDA and you’re basically adjusting it to the number that actually will flow through to a potential acquirer.
Like I do in most videos, I’m going to walk through this with a couple of examples to really drive home the point. My goal is that this will give you a good understanding of some of the key terminology used to value a business. Then in our next video, we’ll take the information that we talked about here and build upon it. We’ll talk about how you actually start using this terminology toward valuing a company. This will help us answer the question, is this business being sold at a reasonable price?
EBITDA and SDE Example
Let’s dive in and just use a basic example, we’re going to use some back-of-the-envelope math to make the examples easy.
Let’s first start with EBITDA. Again, this is earnings before interest taxes, depreciation, and amortization. We have 500,000 EBITDA. Now, if you’re a small business owner, chances are you’re taking some wise actions to reduce your tax burden. Ultimately, you’re paying tax on the earnings that the business generates.
So one of the ways to reduce taxes is ultimately to reduce earnings. It is not uncommon for accountants to help business owners figure out legitimate ways that they can reduce those earnings to pay less in taxes.
SDE Provides Clearer Picture
There’s a popular expression in finance, you’re going to pay what you owe in taxes, but there’s no reason to leave the IRS a tip. The accountant is trying to figure out legal ways that the business owner can reduce their tax burden.
We don’t necessarily care about the earnings of a business. You should care about the true cash value that could accumulate to you as the potential acquirer of this business. SDE or seller’s discretionary earnings tends to be a pretty good metric to help get to that number. What do we do? We take something like EBITDA and we’re basically adding back or removing certain line items from either the P&L or the balance sheet. If you were acquiring the business, you want to see how the company would look from your perspective as the new owner.
Notes Payable Example
One easy example is a note payable. So let’s say this business owner made $500,000, but to make our math easy, they also paid $50,000 in debt payments. Maybe they had an SBA loan, maybe it had another sort of debt financing, it doesn’t matter. Basically, they had to make payments over the course of the year of $50,000.
Typically when you’re acquiring a business, you’re going to buy it in many cases, debt-free. As the acquirer, you are not going to have that debt payment. Therefore, it could be a reasonable assumption to say if this business is at 500,000, the true SDE to an acquirer would be an additional 50,000 dollars, or $550,000 total.
This is because that debt service payment that the owner had made on the previous business is no longer in existence. Now, will the debt payment fully show up in EBITDA? No, technically the principal is more a balance sheet item, and the interest is written off. Let’s just say hypothetically this signals the true value of the company. Then you could make that $50,000 adjustment.
Importance of SDE
Now the key with seller’s discretionary earnings is you’re really trying to get a true value of what would accrue to you as the new owner.
What you’re essentially doing is re-creating the financials in a way that would be in line with your operations. Now, this can cause some back and forth between what should be included and what shouldn’t be included. Put yourself in the seat of the owner. What are the actual line items that would be appropriate or not appropriate to include? Ultimately, you will be able to provide a final earnings number.
This is the amount that’s actually accruing to the business. Then you either have the ability to reinvest that money into the business or draw distributions as an owner. Your business strategy will decide what will be done with the amount accruing.
Conclusion Target Companies of EBITDA/SDE
Typically when we’re in that lower earnings threshold (< $1,000,000), SDE is really popular. When you get up to that next tier, you’re going to start to see EBITDA cited, more frequently. EBITDA is common when the company is large and has established financials, but you can see the two are fairly synonymous.
I hope this video and article gives you a good line of sight into what those are, and some easy ways that you can use a framework to start coming up with the true earnings potential of a business.
If you have any questions or inquires, feel free to reach out through our website.