I wrote last week that businesses are acquired for their earnings or their potential for earnings. And buyers look at earnings when establishing a price they will pay for the business. Typically this is a multiple of earnings. Last week I defined Seller’s Discretionary Earnings or SDE, a common measure used to assess the earnings from a small owner-operated, sole proprietor business.
But, what about a larger business, usually incorporated or run as an LLC? These businesses may be owner managed or the owner may be absentee and typically will not have the owner’s personal bills paid directly from the business checkbook, but will instead include an owner draw or paycheck. They will also own more depreciable assets and may have some intangible “Goodwill” on the books. When evaluating the earnings of this business, we use a term called EBITDA or “Earnings Before Interest, Taxes, Depreciation and Amortization”. This is a more formal method of evaluating and comparing the earnings of larger business to one another. We also normally use this method on the tax return of the business, particularly if the return has been prepared by a reputable CPA or bookeeping firm.
EBITDA, like Seller’s Discretionary Earnings (SDE), is determined by recasting the tax return or P&L statement. The main difference between the two earnings measures is that an SDE will include the owner’s pay in the figure and the EBITDA will not. For example, if you are buying a business as an owner-operator, and will be assuming the management of the operations, you want to know how much money will end up in your pocket if you continue to run the business as it has been run by the previous owner. SDE gives you this information. However, if you are acquiring a larger business and will be hiring a manager for its operations you will need to retain a management salary in any earnings estimate. EBITDA gives you this information and makes the comparison between different businesses more consistent, because all businesses need a manager or management staff to operate efficiently, and this measure allows for that expense to be recognized.
How to determine EBITDA? EBITDA is the net profits of the business, adding back the Interest, Taxes, Depreciation and Amortization. Of course you will want to ensure that all expenses are used for the business and not for the owner, as we showed in the SDE calculation, Then from the tax return (or an accurate P&L statement), take the Net Profits and add back the following:
- Interest paid on long term notes.
- Tax liability for the business.
- Depreciation of tangible assets used by the business in its operations.
- Amortization of intangible assets acquired by the business.
Establishing an accurate EBITDA gives both the buyer and seller a consistent measure and allows more direct communications for negotiating a fair price.