EBITDA and SDE and Multiple Explained
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, we are 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 and Multiples.
What is EBITDA?
EBITDA; shows up in finance mainly and is 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.
What is SDE?
Seller Discretionary Earnings (SDE) is almost exclusively an M&A term. 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 apple to apple 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 SDE.
Typically, small businesses will sell in a one-to-three-times multiple of this figure. Now, this is a wide range, so how do you determine what to apply? The best mechanism is that a one-time multiple is for those businesses where the seller is "the business." In other words: "as out the door goes the seller, so too can go the customers." Consulting businesses, professional practices, and one-man businesses come to mind.
Businesses that have a strong track record, repeat clients, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, or exclusive territory, a growing industry, etc., will sell in the 3-times ratio. The others fall somewhere in-between.
So now the big question: what number/multiple do you apply to the Owner's Benefit number? The answer is simple: nearly all small businesses will sell in the 1-to-3 times Owner Benefit window. Of course, this is a very wide range.
Also, the actual total Owner Benefit figure will impact the multiplier. As the Owner Benefit number increases, so too will the multiple. As an example, a business generating $200,000 in OB, may be worth a 3 times multiple, but one generating $500,000 or $1,000,000 can be worth a four or five times multiple.
When we work on a business valuation we look at historical records of businesses of a similar size, industry, and location to determine the correct multiple to use.
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DealCoach is headquartered in Green Bay Wisconsin with an office in Milwaukee Wisconsin and helps customers find out how much their business is worth with online business valuations and advisory services. Our business valuations also known as an Estimate of Value (EOV), help prepare buyers and sellers for the sale. DealCoach also helps business owners grow value with a Business and Market Analysis and plan for retirement, estate & financial planning, benchmarking, and strategic planning. DealCoach servers and has provided business valuations for businesses located in the United States and Canada.
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