At SBALenders.com, we interact with many buyers of businesses, and some of those find their acquisition targets on online marketplace such as BizBuySell or via business brokers like Sunbelt Network. Nothing wrong with those approaches, but it is important to take into consideration how traditional business brokers calculate profits versus a bank’s definition, which may be materially different.
There are many definitions and acronyms buyers and sellers utilize to define profitability of a business. In this article, we will be discussing the differences between Seller’s Discretionary Earnings (SDE) and Earnings Before Interest, Taxes, Depreciation, and Amortization(EBITDA), and why business brokers prefer SDE and bankers prefer EBITDA. But first, a primer on popular terms related to earnings:
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): EBITDA provides an indication of a company’s cash flow and operating profitability. EBITDA is commonly utilized by capital providers – banks, investors, and buyers of business – to determine the cash flow of the business prior to any debt payments (i.e., principal and interest payments) and capital expenditures (e.g., equipment, real estate, or other long-term assets).
SDE (Seller’s Discretionary Earnings): This is the total income generated by a business, including both the profit and the owner’s salary, benefits, and any other discretionary expenses. SDE provides an indication of the true cash flow generated by a small to medium-sized business. Business brokers, who typically represent the sellers of small businesses, typically state profitability in terms of SDE because it makes the business appear more profitability.
We will go into the reasons why EBITDA is preferred over SDE by financiers in a moment, but first we wanted to define some of the other profitability terms in financial nomenclature:
Free cash flow (FCF) is a measure of the amount of cash that a company generates from its operations after accounting for all capital expenditures required to maintain or expand its business. It is the cash that is available for distribution to investors or for other purposes such as debt reduction or share buybacks.
Free cash flow is calculated by subtracting capital expenditures from operating cash flow. Operating cash flow is the cash generated by a company’s core operations and is calculated by adjusting net income for non-cash items and changes in working capital.
The formula for free cash flow is: Operating cash flow – Capital expenditures (Cap Ex)
In other words, free cash flow represents the cash that a company has available after it has paid for all of its operating expenses and capital expenditures, and it can be used to pay dividends, reduce debt, or invest in growth opportunities.
Free cash flow is a key metric for investors and analysts because it provides insight into a company’s financial health and its ability to generate cash. A positive free cash flow indicates that a company is generating more cash than it is using to maintain or expand its business, while a negative free cash flow indicates that a company is using more cash than it is generating. A company with consistently positive free cash flow is generally considered to be in a strong financial position.
Another way to think about free cash flow is EBITDA – Cap Ex, which is the amount of cash available for debt service.
EBIT (Earnings Before Interest and Taxes): This is the net income generated by a business before taking into account interest and tax expenses. EBIT provides an indication of a company’s operating profitability. EBIT is EBITDA less the +DA” – the depreciation and amortization. For businesses with high capital expenditures, often capital providers will look at EBIT as an estimate of cash flow, with the assumption being the DA approximates capital expenditures.
Net income: This is the revenue generated by a business minus all expenses, including interest and taxes. Net income provides an indication of a company’s overall profitability. Net income is often referred to as a company’s “bottom line.”
Gross profit: This is the revenue generated by a business minus the cost of goods sold. Gross profit provides an indication of a company’s profitability before taking into account operating (aka overhead) expenses. Gross profit is perhaps the least meaningful profitability metric.
SDE versus EBITDA
The primary difference between SDE and EBITDA is that SDE includes the owner’s compensation and discretionary expenses (aka “addback”), while EBITDA focuses solely on the company’s operating performance. This difference makes EBITDA a more reliable measure of a company’s profitability, as it eliminates the impact of owner compensation, which can vary widely from company to company, and addbacks that aren’t justified.
Addbacks refer to adjustments made to a company’s financial statements to account for expenses that are not considered part of its core operations. While addbacks can provide a clearer picture of a company’s financial performance for a privately-held business, they are sometimes viewed skeptically by banks and other lenders when determining profitability because sellers tend to “addback”
to the earnings of the business expenses that the buyer will have to assume. Sellers want a higher “earnings” number, so their representatives deploy SDE, which is simply EBITDA + addbacks
Here is one example with some of the common addbacks we see along with the buyer’s and/or banker’s rationale for denying the addback into the earnings calculation:
Note the valuation for the earnings from the business are $3.25 million from the seller and $1.875 million from the buyer. Also, in this example, the seller is asserting the business will generate $650,000 in annual cash flow before debt service. The buyer (and her banker) believes $375,000 is the correct number.
In today’s climate with interest rates around 10%, an SBA lender will only lend 5x earnings of a business because the debt service (i.e., monthly principal and interest payments) will approach 20% per year, so the business must generate 20% (1/5) of the loan amount annually to cover those loan payments.
The net takeaway for potential buyers is addbacks aren’t adding back to earnings if the expense will continue after the acquisition. If you are replacing the owner and will take a salary, that’s not an addback that can be used to adjust historical earnings.
While addbacks can provide useful information when evaluating a company’s financial performance, banks and other lenders are more cautious when using them to determine profitability. SBA banks and other lenders typically prefer to focus on more objective measures of cash flow and profitability, such as EBITDA, when making lending decisions. Typically, banker will focus on the EBITDA as reflected on the federal tax return.
When valuing small to medium-sized businesses, online business brokers often use SDE as a basis for calculating the business’s market value. This is because SDE provides a more accurate picture of the true cash flow generated by the business, which is essential for determining its worth.
To calculate SDE, online business brokers start with the business’s net income and then add back various expenses that are considered discretionary or non-recurring. These expenses may include owner’s salary and benefits, depreciation, amortization, interest payments, and any other non-essential expenses.
In conclusion, while SDE and EBITDA are both important financial metrics, EBITDA is preferred by banks due to its focus on a company’s operating profitability and its widespread use as a standard financial metric.