What the business really earns: SDE, EBITDA and add-backs

The short version

• Buyers value a business on what it earns for an owner, measured as SDE or EBITDA, not on revenue.
• Both start from profit and add back costs a new owner would not have. These are add-backs.
• Some add-backs are real. Some are generous. Each needs proof.
• A lender will test the add-backs too, and often accepts fewer than the seller.
• Rebuild the earnings yourself before you rely on them for your price.

SDE and EBITDA

SDE, seller's discretionary earnings, is what the business produces for one full-time owner, including the owner's own pay.

EBITDA, earnings before interest, taxes, depreciation and amortization, is what the business earns after paying someone a fair salary to run it.

Which measure applies. A common guideline: businesses earning less than about $1 million a year are usually measured on SDE. These are typically run by their owner, and the buyer will often step into that role. Once a business earns more than about $1 million in EBITDA, buyers usually expect a paid manager to run it, and EBITDA becomes the more common measure.

In practice, it varies. Brokers, lenders and buyers each have their own habits, and the same business can be described both ways depending on who is looking at it. Some SBA lenders work from SDE well above $1 million. Some brokers price smaller businesses on EBITDA. What matters is knowing which measure a number is based on, and comparing it only with benchmarks that use the same one.

A multiple of SDE and a multiple of EBITDA are not the same. Always check which one a price is based on.

What add-backs are

The seller's tax return shows profit after every expense. Some of those expenses exist only because the seller owned the business. Adding them back shows what the business earns for a new owner.

Common add-backs:

• The owner's salary and benefits, for SDE.
• Interest, depreciation and amortization.
• Personal expenses run through the business, such as a personal vehicle.
• Family members on payroll who do not work in the business.
• One-time costs that will not repeat, such as a lawsuit or storm repair.

Testing each one

For each add-back, ask:

• Is there proof? A receipt, invoice or payroll record.
• Will it really go away? A vehicle used for the business is a business cost, even if the owner drives it home.
• Is it truly one-time? A "one-time" repair that happens every year is a normal cost.
• Will you have new costs the seller did not? A manager to replace work the owner did for free, market rent if the seller owned the building, raises for underpaid staff.

What lenders accept

Lenders review add-backs carefully. Add-backs without records are often rejected. Lenders also confirm tax returns directly with the IRS, so income that was never reported cannot be counted.

When the lender accepts fewer add-backs, earnings fall, and so does the price the loan will support. Lesson 3.4 covers the lender's test.

Rebuild it yourself

Start from the tax return. Add back only what you can prove and believe. The result is your number, not the seller's. Use it in every calculation from here on.