SDE vs. EBITDA

We don’t use SDE (seller’s discretionary earnings) in the ca. 70-80 valuations we do every year, but if you are buying or selling a firm, it’s important to understand the distinction between SDE and EBITDA (earnings before interest, taxes, depreciation, and amortization).

Definitions

SDE is the sum total of the owner’s compensation and the discretionary expenses that the owner might run through the business, whether actual or disguised business expenses. In this latter category, you might find some travel, an automobile, disability insurance, etc. SDE is meant to surface how the business contributes to an owner, including some of the strange things you might also see (boat, artwork, etc.).

EBITDA is a more serious calculation that does not include owner compensation. It assumes that an owner is necessary, and that if this owner is gone, the buyer will have to compensate whoever is going to run the firm in that person’s place. EBITDA is arrived at by looking at net profit, and then adjusting for those four elements (interest, taxes, depreciation, and amortization). These are deducted from expenses…or added back to net profit…as you prefer, since the result is the same. The principal’s comp will usually be normalized, too, ensuring that the owner is not subsidizing net profit by just underpaying themselves. And then the personal expenses, if the argument is solid, can be construed as “addbacks”, further increasing the calculated EBITDA. The addbacks would include those same personal expenses that are included in SDE calculations, but the addbacks can also include many other elements: rare legal expenses, a one-time build-out, that rare client who didn’t pay a big invoice, etc.

When SDE is Used

This is not always the case, but you can generally assume that SDE is used when

• EBITDA isn’t favorable.
• Lots of personal expenses are classified as business expenses.
• Firm is small.
• There’s only one owner.
• Enterprise  doesn’t require owner involvement.

Other advisors are going to disagree with this, but in our world, SDE is a non-serious calculation that screams “look deeper” please.

When EBITDA is Used

We only use EBITDA in our valuations, and if you ever see us using SDE, we’re definitely trying to sell you something, which is not our style. Besides, EBITDA is required, by definition, when:

• There are multiple owners.
• Principal compensation should be normalized, which it always should.

That doesn’t mean we don’t make adjustments, because we will. But these are always legitimate addbacks that can be defended. When we’re working across the table from a buyer or seller’s agent, they will quickly see a refreshing transparency in our work. That doesn’t mean we won’t fight hard for whoever we are representing, but you won’t see us using SDE in our valuations, largely because this is a field where owners are involved and it’s unrealistic to assume that owning an agency is like owning a self-storage unit.

All Those Extras

What we do like about SDE is that it’s an honest picture of all the perks you’re taking in running the firm. But the better approach is to get the illegitimate ones off the books and treat the legitimate ones as addbacks, fully supported with documentation.

While we’re on this subject, how about we give you a solid idea of what your firm is worth, including a way to update this over time as you plan for the future? And don’t miss our passive sellers database for people who aren’t actively looking for a buyer but might be open to an offer if it’s the right one.