The differences between EBITDA and Seller’s Discretionary Earnings (SDE) cause confusion. Sometimes the two terms are incorrectly viewed as interchangeable, but there are important differences.
First, some definitions. Both are business performance benchmarks that are widely used in valuing a business for sale or acquisition. However, there are critical differences in EBITDA and Seller’s Discretionary Earnings, and if you use the wrong one in valuing the company under consideration, you could calculate a grossly inaccurate appraisal of the business.
EBITDA is defined as earnings before interest, taxes, depreciation and amortization. In other words, to compute EBITDA you take the net profit of the business as shown on the company’s tax return or P&L and add back the interest, taxes, depreciation and amortization. Only these four items are allowed to be added back. The resulting number of this calculation is EBITDA. It’s by far the easiest benchmark to compute because the adjustments to net profit or loss are limited and well defined.
Seller’s Discretionary Earnings (SDE)
In computing Seller’s Discretionary Earnings (SDE), you again start with the net profit or loss of the business and add the items listed above for EBITDA. Then for SDE, you also add back some other items. Those additional items are the business owner’s salary and perks, any one-time expenses not likely to recur (ie: a major remodeling expense), and any expenses that will disappear for the new business owner.
As just one example, let me tell you about the sale of a restaurant that I handled as a business broker several years ago. The profit and loss statement from the business was actually showing a small loss.
However, the owner’s wife drove a Lincoln Navigator which was listed on the books of the business as a company vehicle. The company also paid for all her gas and maintenance on the Navigator although she had no role in the operation of the restaurant. Same for the daughter’s Honda which she drove back and forth to college. The daughter was also on the payroll as an employee of the restaurant which furnished her with spending money at college, although she never actually worked at the restaurant.
The family’s week-long ski vacation to Colorado was charged to the business because the owner attended a business meeting for a few hours while in Aspen. You see where I’m heading here, don’t you? By the time all these items plus any non-cash expenses (eg: depreciation) were accounted for, the restaurant was actually producing a nice yearly discretionary income for the family.
DISCLAIMER: Hey, I’m not with the IRS and don’t render an opinion on these sorts of things!
Simply put, the calculation of Seller’s Discretionary Earnings is an attempt to determine the business owner’s total financial benefit derived from owning the business.
With the differences between EBITDA and Seller’s Discretionary Earnings, which one to use?
So with the differences, which one of these benchmarks do you use when buying or selling a business? More than anything else, it depends on the size of the business.
For large businesses, usually with a professional non-family CEO running the company, EBITDA will yield a more accurate result of market value. These businesses are usually the ones being sought by private equity groups or considered by publically traded firms as a merger candidate.
But for smaller businesses, usually run by an owner-operator and with annual revenues below, say, $5 million, the calculation of Seller’s Discretionary Earnings will be much more meaningful.
For additional information on related topics, these articles may be helpful:
- How to Use Valuation Guidelines to Estimate the Value of a Business
- How to Analyze a Business You’re Considering Buying
- How to Make a Written Offer to Buy a Business
- Seven Negotiating Rules When Buying or Selling a Business
- How to Conduct Due Diligence When Buying a Business
- Here’s the New $600 Billion Loan Program for Business Hurt by the Pandemic
Please don’t hesitate to call or email if my office can be of assistance.
Hi William, Thank you for shedding some light on this topic. I chuckled at your “DISCLAIMER”, but it does raise a serious question. Your credentials would seem to give a potential buyer confidence that they’re entering a negotiation where some expertise has been applied before the seller put up his business for sale. Since there could be so much room for differences between EBITDA and SDE, do you recommend (or even require?) your clients to provide recently AUDITED financials – beyond just tax returns – when they prepare their business for sale? Your disclaimer reminds us all that no buyer would want future IRS troubles, so as way to instill “peace-of-mind” for potential buyers, I’m wondering how all this plays-in to the asking price and the starting point of a potential sale-of-business transaction. Thanks! -Julian Reid
Julian, thanks for dropping in. Great to hear from you. Truly audited statements by a CPA firm are expensive with $15,000 being probably the minimum cost for a small business. I’ve only had one truly audited statement from a “Main Street” seller in the last 30 years. We rely on the tax returns for “Main Street” businesses and are conservative in the add-backs we’ll use in computing Seller’s Discretionary Earnings. Let’s have lunch when you’re next in the area. -Will
Julian, as I was typing my previous response to your comment, I failed to answer your question about the buyer’s liability. Ninety-plus percent of the transactions I handle are asset sales, meaning legally that the acquiring entity (whether sole proprietorship, corporation, LLC, etc.) acquires “selected assets” from the selling entity. Those selected assets are usually all of the operating assets of the selling entity including the trade name. The buyer DOES NOT buy the shares of stock or memberships position in the selling corporation, LLC, etc. In these kinds of transactions, any tax liabilities remain with the selling entity. I remember from law school that, I believe, the only liability that does follow the assets regardless is unpaid payroll taxes.
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