- The foundational principles behind SDE and EBITDA in business evaluations.
- How SDE and EBITDA impact business valuations and transaction negotiations.
- The distinct components and calculations underpinning both SDE and EBITDA.
- The significance of these metrics in the larger context of business acquisition.
- The contrasting applicability of SDE for smaller businesses versus EBITDA for larger entities.
Understanding the difference between SDE and EBITDA – two crucial metrics in business acquisition – is paramount if you’re looking to get a grasp on how much money you stand to earn once you close the deal.
These indicators not only paint a picture of a company’s profitability but also deeply influence the negotiation, valuation, and final transaction terms.
While they both serve to depict a business’s earnings, their applications and details differ.
This article delves into the intricacies of SDE and EBITDA, examining their components, calculations, and relevance in the acquisition landscape.
Let’s look at the difference between SDE and EBITDA.
What is EBITDA?
EBITDA, an acronym for “Earnings Before Interest, Taxes, Depreciation, and Amortization,” is a barometer for a company’s operational profitability.
Excluding non-operating expenses clearly represents a company’s core business operations.
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It’s a metric commonly employed by larger corporations to assess their financial health and attractiveness to potential investors or buyers.
EBITDA Calculation Explained
To calculate EBITDA, begin with the company’s net income and add back interest, taxes, depreciation, and amortization.
The logic behind this addition is to focus purely on the operational earnings, sidestepping external financial costs and non-cash accounting estimates.
Example: HVAC Business A
Let’s consider HVAC Business A, a hypothetical heating, ventilation, and air conditioning business:
- Net Income: $300,000
- Interest Expenses: $20,000
- Taxes Paid: $50,000
- Depreciation: $15,000
- Amortization: $5,000
Using the formula, EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization, HVAC Business A’’s EBITDA would be $390,000.
What is SDE?
Seller’s Discretionary Earnings (SDE) essentially modifies the EBITDA concept by adjusting for the unique financial decisions and benefits of business owners, especially in small to medium-sized enterprises.
One of the primary reasons SDE is relevant for small businesses is due to the significant role the owner-operator often plays.
He or she wears multiple hats – they might act as the manager, salesperson, accountant, and even as the primary service provider.
Their compensation, therefore, might be a mix of regular wages, benefits, discretionary expenses, and distributions, which could be substantially different from a traditional salary structure in larger corporations.
In other words, SDE may need to be adjusted upwards or, more often, downwards to reflect the true market value of the salary that would be paid to a General Manager of the company hired from outside. Once this is adjustment has been made and extraordinary benefits and one-time expenses have been removed, what remains is the true operational profit.
SDE Calculation Explained
To determine SDE, you start with the net earnings of the business.
Then, as you did for EBITDA, add back, interest, taxes, depreciation, and amortization..
This gives you an interim picture of operating profit. Next, you have to consider what a fair market salary for a GM replacing the owner should be. The owner/operator might have taken $300,000 a year out of the company as the owner’s distribution (and had every right to) or, conversely, may have taken only $30,000. Regardless, you will have to pay a GM the market rate when you step back from the business. So add that market salary and associated benefits back into operating expenses, reducing the operating profit.
In addition, the owner may have booked expenses to the business that were personal, in part or whole – for example, family cars, vacations, perhaps a health club membership. You have to look for these too and then remove them from expenses, increasing the operating profit.
Finally, there may be extraordinary expenses which do not normally appear on the books. Examples might be one-time legal expenses to defend a lawsuit, one-time accounting expenses to straighten out books that were a mess, or the expense of a marketing campaign that was a failure and abandoned. These should be removed.
These addbacks (which may increase or decrease operating expenses) are meant to provide a potential buyer with a more transparent picture of the earnings they might expect once they acquire the business.
Example: HVAC Business B
Consider HVAC Business B, another hypothetical HVAC company:
- Net Income: $300,000
- Salary and Benefits for GM at Market Rate: -$145,000
- Interest Expenses: +$10,000
- Taxes: +$30,000
- Depreciation: +$10,000
- Amortization: +$5,000
- Extraordinary Expenses (e.g., extraordinary legal expense): +$10,000
- Discretionary Expenses (e.g., family vacation): +$15,000
SDE = Net Income – Salary/Benefits at Market Rate + Interest Expenses + Taxes + Depreciation + Amortization – Extraordinary Expense – Discretionary Expense, or in this case $235,000.
Note that without the effect of these addbacks SDE would be $355,000.
SDE vs EBITDA
While EBITDA and SDE both aim to represent the earnings of a business, their primary distinction lies in their applicability and scope.
EBITDA focuses on operational profitability, and is primarily used for larger corporate evaluations.
SDE, on the other hand, tends to be distorted by the owner’s freedom (fully legal) to take any cash they want as salary out of the business, and run personal expenses through the business. SDE therefore tends to be muddier and requires more effort from the buyer to determine the addbacks that must be made to get a clear picture of operational profitability. The addbacks may be positive or negative.
EBITDA And SDE Multiples
In business valuations, SDE and EBITDA multiples are significant. It is common to value a business by taking one or the other and applying a multiple to come up with a starting bid for a business.
The actual multiple varies depending on a variety of factors, including location and industry, but an example would be a business with an EBITDA of $1M with an industry norm of 3-5X. A standard offer to buy the business would be in the $3-5M range.
A “good” SDE multiple varies by industry and business size. Generally, for small businesses, multiples range from 1-4x SDE. However, factors like growth trends and market demand can influence this multiple.
EBITDA margins can vary widely between industries, so researching industry standards is crucial before embarking on an acquisition. They can also vary widely based on location, scale, and management efficiency. HVAC businesses often range between 10% to 25%, roofing sits between 5% to 15%, and plumbing ranges from 10% to 20%.
Adjusted EBITDA refines the standard EBITDA by accounting for irregular or one-time expenses and income, offering a clearer depiction of a company’s core operational performance. It provides investors and stakeholders with a more consistent view of business health, excluding non-recurring financial anomalies.
Having a solid grasp of the difference between SDE and EBITDA is a key aspect of becoming a successful acquisition entrepreneur.
Their differences and potential pitfalls, as elaborated in this article, underpin their critical role in influencing acquisition decisions.
For potential buyers and sellers, choosing the right metric, understanding its intricacies, and being aware of its implications are paramount in ensuring a fair, transparent, and beneficial transaction.
Are you an aspiring acquisition entrepreneur looking to learn more about SDE and EBITDA? Consider reaching out to Acquira and taking our Accelerator. This supercharged, MBA-level training could see you owner of a $1MM/year cash-flowing business in as little as seven months. You’ll get guidance from Acquira’s experience success coaches, weekly group calls, invaluable feedback from our investment committee – and much more.
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- SDE offers a broader profitability view, factoring in owner benefits and discretionary expenses.
- EBITDA provides a clear perspective of a firm’s primary operational efficiency.
- The choice between SDE and EBITDA can influence the perceived business value.
- Understanding SDE and EBITDA is crucial for informed business acquisition decisions.
- Adjusted EBITDA delivers a more precise measure of a company’s continuous operational health.
Acquira is a business acquisition in a box service. We help entrepreneurs buy businesses and we invest in them and their chosen businesses. We are here to help ensure that each business we work with is posed to make the biggest positive impact possible for its owners, employees, and community.