What is EBITDA/SDE, and Why are they Important?
When selling a business, showing potential acquirers how much money they stand to make from running the business is essential. Seller’s Discretionary Earnings (SDE) is a metric utilized to demonstrate the potential earnings a person could obtain from owning and operating a business. SDE is derived by combining the normalized EBITDA of the business with the FMV (fair market value) of an owner’s compensation for his/her involvement in the business operations. Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is a standard metric that illustrates a business’ operating earnings, excluding non-cash expenses. EBITDA should not be the exclusive metric to reflect a business’s earnings. EBITDA may be inaccurate due to one-time, non-recurring irregularities. For this reason, it is vital to nullify the effects of irregular expenses and benefits to arrive at an accurate normalized EBITDA.
EBITDA as a metric – pros and cons:
Pros:
- EBITDA considers the earnings of a business in a purer form, not accounting for non-cash and non-operating expenses.
- EBITDA neglects the deduction of interest and taxes specific to each owner’s operations.
Cons:
- EBITDA does not offer a comprehensive picture of a business’ cash generation. Deducting amortization without providing an accurate and meaningful Capex distorts the business’ earnings estimate.
- EBITDA does not consider the Interest and taxes of a business, which are the true costs of operating a business.
Normalizing EBITDA:
The steps to arrive at a normalized EBITDA are as follows:
- Adjust for discretionary expenses: Identify and reintegrate non-core business expenses, including but not limited to professional memberships, company parties and office decor. Discretionary expenses must be included in EBITDA because they are classified as non-core business expenses. The company could operate without incurring these expenses.
- Adjust for one-time non-recurring expenses: One-time expenses such as an IT upgrade or an office renovation are added back to eliminate distortions caused by unusual expenses.
- Adjust for the owner’s compensation: Adjust the owner’s compensation to a fair market value. An unrealistic owner’s compensation has the potential to decrease the business’ EBITDA artificially. Add back the owner’s compensation and proceed by deducting the fair market value of what a CEO of a comparable company has the potential to earn annually.
A word of caution when basing a valuation on EBITDA:
When valuing a company based on a multiple of EBITDA, here are some critical questions to answer:
- Does EBITDA reflect Cash flow in this particular business? EBITDA adds back capital expenditures such as depreciation and amortization. Cash flow would account for capital expenditures in property, plant and equipment, while EBITDA neglects the costs incurred by these capital expenditures.
- What is the Capital structure of the business, and how does it affect EBITDA? Consider the proportion of debt and equity the business has. The interest expense on this debt will not be factored into EBITDA. This can cause a distorted perspective of the company’s earnings, disregarding the substantial cost of debt interest.
- Are normalizations justifiable and truly non-operating? A corporate travel expense incurred for attending a trade show for commercial purposes is a fundamental business expense and should not be categorized as irregular.