Understanding the financial health of a business is key to determining its value and, thus, what it can be sold for on the market. One way to understand the value of a business is to calculate the seller’s discretionary earnings (SDE).
What is SDE, exactly? How does it differ from EBITDA, the number most middle-market businesses are used to calculating? And how do things like net income and cash flow factor in? We’re going to answer all of these questions - and a few more along the way. Let’s start by defining our terms.
What is cash flow?
Cash flow is the amount of money flowing into and out of a business. There are various ways of using cash flow to evaluate the financial health of a business, from debt-service coverage ratio (DSCR) to free cash flow (FCF).
While cash flow can be relevant in certain calculations, only specific inflows (money coming in) are used to calculate SDE. Anyone who is looking to purchase a business should be interested in the cash flow of that business, but as cash flow is the big picture and not in and of itself an accurate measure of profitability, it’s not used as a final measure of the value of a business.
What is net income?
Net income is, in essence, a company’s inflow minus its outflow (the amount of cash leaving the business). More specifically, it’s the sales of a business minus the cost of goods sold, expenses, depreciation, interest, and taxes.
When you hear businesses talking about “the bottom line”, they’re referring to net income. Shareholders of large corporations will often use net income to understand how much profit is being made per share.
Net income, like all financial statements, is useful in understanding the value of a business, but it’s not perfect. For the purposes of Main Street businesses, it’s more useful to use metrics like SDE, which is calculated using earnings before interest, taxes, deductions, and amortization (EBITDA) plus the seller’s compensation.
What is EBITDA?
EBITDA is an alternative to net income in which interest, taxes, depreciation, and amortization are added back to the bottom line of a company. EBITDA and its derivative, SDE, are two of the most commonly used metrics for establishing the value of businesses worth $5 million or less.
How is EBITDA calculated?
The first step is to take the net income of a company, then add back interest and taxes - this process gives you a figure known as EBIT. Let’s say a company has a net income of $300,000, but that business paid $30,000 in taxes and $20,000 in interest. You would add those figures back to the net income (as they would have been subtracted to find the net income in the first place).
Net income: $300,000
From there, we can add in the non-cash values of depreciation and amortization. In this example, our business has reduced its net income by $20,000 in depreciation but has no amortization on the books.
Why is EBITDA used?
As we’ve mentioned, net income and cash flow are both incredibly valuable tools for evaluating the health of a business. At first glance, they seem to give a more complete picture of financial health than EBITDA, so why is it so commonly used in business valuation for Main Street businesses?
The answer can be found in the nature of interest, taxes, depreciation, and amortization. Many business owners see these figures as more flexible than, say, net revenue from sales. Interest can be reduced by restructuring loans and by seeking out different lenders. Taxes can vary wildly from year to year. Depreciation and amortization are non-cash values that can similarly fluctuate substantially from year to year. (Note: Some businesses that are equipment-heavy will only have part of the Depreciation and Amortization added back when determining EBITDA and SDE.)
EBITDA also allows buyers to compare businesses in different jurisdictions, as taxes are added back to net income. Finally, EBITDA can help you compare two businesses with the same net income. One business might have a higher EBITDA than the other, which could signal that a given business is under or over-borrowing.
Of course, anyone who is trying to determine the value of a business should look closely at cash flow and net income - don’t rely solely on EBITDA. A business that’s absolutely drowning in debt might look solvent if you’re only looking at EBITDA.
What is SDE?
The Seller’s Discretionary Earnings (SDE) is a figure calculated by adding the owner’s salary to EBITDA. This is relevant to smaller businesses, as the new business owner will want to determine how much they might net yearly as take-home pay.
Imagine a seller has a yearly salary of $100,000. Added to the EBITDA we calculated before, we get:
+Owner’s salary: $100,000
We’ve calculated the SDE, to which a multiple will be applied depending on the industry in order to calculate the fair market value of the business. (Note: If the Owner’s salary is a fair market salary for their work, then often the Owner’s salary will not be added back.)
Abnormal revenue and expenses
There are some expenses and revenue streams that are completely atypical for a business and should thus not be factored into SDE.
A perfect example from recent years is COVID subsidies. We recently published a white paper on how COVID subsidies affect EBITDA (and thus SDE) - we highly encourage you to read it to better understand the value of your business.
Let’s assume our business received $20,000 in COVID subsidies that don’t need to be repaid. In many circumstances (read the article linked above for a deeper understanding), these subsidies would be reduced from our SDE before adding the multiplier.
+COVID subsidy: ($20,000)
From there, we use our multiple (let’s say it’s x2.5 for this particular business/industry):
$450,000 x 2
Fair Market Value (FMV) = $1,125,000
Want to find the value of your business? Call Jason Brice today
Jason Brice is a Vancouver business broker who specializes in the sale of businesses whose value ranges from $500,000 to $5 million. For these businesses, EBITDA and SDE are the industry standard for determining fair market value.
As you’ve just learned, however, business valuation is very complex - there’s a lot of information to be found in anything from cash flows and net income to irregular subsidies and expenses. Before trying to sell your business, get a professional opinion on its value and get the right industry multiple. Talk to Jason!