SDE vs EBITDA for Business Valuation: Key Differences

[00:00:00]All right, perfect. Welcome back. Thanks for joining me, Sarah. So, just a quick introduction. Welcome to the business exit and acquisition playbook. I'm Trent Lee. Happy to dive into SDE versus IBIDA. What's the difference? When to use them, and what do you need to know?

[00:00:19]So, my guest today, Sarah Grossman.

[00:00:22]We've been friends for what, four or five years? Has it been that long?

[00:00:26]>> Yeah. Time flies, right?

[00:00:28]>> Yeah. one of the best business brokers out there. So, when I thought about who would be a good interviewee to come on this podcast and start diving into some of the details with me, your name popped up and thankfully she was uh willing to do it. So, just a really quick background here. Most buyers argue on price, >> but the pros get the cash flow right. So if you mix up SDE and IBIDA, you could end up overpaying bank fail the bank review, burn months of time wasted on deals that you shouldn't be. And so today we're going to talk about the tools that you need to know. What's the difference? When to use it, do you use both of them? Adbacks, what do you need to know? And so basically just a little 101 course on adbacks, SDE, EVA. So Sarah, tell me just let's go to the basics. How do you define SDE versus EVA? In case someone doesn't know and they're going through buying a business for the first time, what do you tell them?

[00:01:25]>> Yeah, when I first look at a business, I look at who's the buyer, right? Who's the eventual buyer and what's their role in the business? So, I think for most of our, I guess we call main street companies, they're going to be bought by an individual buyer. So, that buyer is buying a job. They're walking into the same seat as the seller. And so, in those instances, I usually use SDE. And I also we have you have to look at it as one single owner operator. So if you have a husband and wife running the business, they're both getting an officer's compensation. You really have to look at how much will one person walking into that business make, right?

[00:01:58]And then back out a replacement salary for the other. Even I usually use for larger companies. I think about it companies bought by a strategic buyer, maybe private equity. those companies when someone's bidding on those companies, they're trying to look at the company fully loaded with all of the seats filled with salaries, right? So, if the owners there running the business, you remove them. How much do you have to replace them as a CEO? So, I come at it as I think some of it's the size of the company and some of it is who is the buyer and what's their role going to be in the company?

[00:02:32]>> Yeah. Now, when I'm talking with buyers, I really give them a analogy of it's like wearing two sets of glasses. SDE glasses basically show what a single working owner would get. And to your point, a single working owner is key, right? Don't get sloppy adbacks from brokers who try and add back both owners that are full-time in the business. And then I pair of glasses is shows what the company would earn with a manager in the seat is how I approach it. So what do what is there a price range where you look at a benchmark where you say okay it's a million dollars and above or below one uses SDE or is it really just truly based on the buyer's intention if they're going to be an owner operator?

[00:03:19]>> Oh that's a good question. I think a lot of times we're recasting. If it's a business, I would say selling for under threeish million. Most of those are going to be an owner operator. We're using SDE. And then I would say 3 million on up. Sometimes the 3 to5 million range, we'll do SDE and IBIDA because some of those businesses could be bought by an individual. Some of them could be bought by a strategic buyer.

[00:03:41]So, we are showing them both ways. And I know later on we'll talk about valuation and how that plays into the numbers. and they're really businesses over $5 million. I'm really looking at IBIDA.

[00:03:51]So, I really am baking in all the salaries that are needed to run that company and then coming back with an IBIDA calculation. And it's also very interesting like I had this debate and we can talk about it later with someone actually like a CPA who was like mixing up SD and IBIDA. So, it's not so intuitive. Not everybody knows how to do it and they were actually getting it wrong. And I think it's really important obviously to understand the differences and to get it right when you're making an offer and looking at a business.

[00:04:16]>> Yeah. And that's key because there's really no handbook out there that says here's the actual black and white bridge from one versus the other. When is it appropriate? There's a lot of different opinions out there. So, it's good just to get general knowledge about it. And to your point, unfortunately, CPAs don't really sell businesses and so they don't necessarily know the difference either as well.

[00:04:38]>> Yeah. And I think also like in this case, it was a family business, two owners in the business. They paid themselves a total of about $300,000 in salary and we calculated it would probably be closer to $400,000 to replace them. You need a CEO and a CFO.

[00:04:54]My opinion was you've got to make that adjustment, right? You have to make the adjustment from 300 to 400 to have two people replaced. The CPA's opinion was leave in the salary that they're taking, let the buyer go and tell you what salary they want to put in for the replacement. So, it was two different ways of looking at it. I had never actually looked at it that way. I'm not sure frankly which one is right. I usually try to adjust in what the fair market salaries are. His perspective was we think it's close enough. This is what they're taking as a salary. Let the buyer calculate. And the buyers are smart and they're larger private equity strategic buyers. Let them come back and say the salaries they need to put in the business to make their own eBay calculations.

[00:05:33]>> Yeah, it's interesting. And I always in those type of situations where there's clearly no real true right or wrong answer, I usually just tell them, look, it's whatever buyer and seller agree to, but we want to try and make a educated guess when we at least take it to market, but ultimately it's up to the buyer and seller. So for sure >> when it comes to SDE calculating sellers discretionary earnings obviously we're looking at IBIDA plus owner's wages plus some adbacks but what are some typical adbacks that you in your mind like common easily accepted adbacks and then we'll talk about the flip side. What are some maybe pushing the envelope adbacks that we want to be careful about?

[00:06:12]>> Yeah, I think easy adbacks are the payroll taxes associated with the owner's compensation that they're taking. I think if they have their own cell phones they're running through the business, if they have a car payment that they're running through the business, any personal meals and entertainment expenses, also one-time expenses. So, let's say they upgraded their technology systems or they put in a new system in place that the buyer doesn't have to replicate, right?

[00:06:36]There's a kind of a one-time expense for that. and we adjust for that. If they own their property and they're either paying above or below fair market rent for that property or what a buyer would have to pay for that property, we have to adjust for that as well. And then there's typically interest. So if they have their own interest expense, we always add back that depreciation, amortization. So those are the typical adbacks. I think it can get dicey when you're getting to a lot of a million different adbacks in a million different buckets because some of them may or may not be accepted. I know in Massachusetts we have the debate on health insurance, right? So you can add back health insurance, but the debate is that a buyer in Massachusetts you're required to have health insurance. So how do you add that back and say it's discretionary when a buyer has to have health insurance. So sometimes we do have that adback, but the bank sometimes debates that when they're looking at the loan.

[00:07:26]>> Yeah. I always tell my buyers when I'm working with them, what we're really trying to do is create a bridge between IBIDA and SDE. And the best way to remember that is bridge is an acronym.

[00:07:38]So that's my like approved adbacks. B is the base owner's pay. R in the bridge is rare one time costs like really truly one time, not like your every other year machine equipment. I is interest taxes amateization.

[00:07:57]D is depreciation. And then G on that bridge acronym is like goodies, personal goodies, car, phone, travel, health to your point, whether it's some states to your point are okay with that, some aren't. And then finally, E in the bridge acronym is extraordinary items like that clearly won't continue.

[00:08:19]>> The key though is you have to have proof. You have to have verification of these adbacks. At least the way I'm approaching this. And so I want to make sure that if buyers are looking at my own or other listings that there's some real documentation to prove that's an adback, not just some random number that people are saying we should add back.

[00:08:41]>> Yeah. And I think that's a really important point. I think sometimes sellers are like, "Oh, I put $25,000 on my business credit card for personal stuff every year." If you can't tell me where it is in your P&L, yes, you can be putting it on your credit card, but your accountant may not be expensing it. It has to show up as an actual expense on your P&L and that you can verify where it is in that expenses. I can't tell you how many times I'll ask clients for their adbacks and they'll say, "Oh, my cell phone $5,000." And I go to the P&L and the line item is like $3,000. And I'm like, "You told me it was $5,000.

[00:09:16]You guessed it's really three. I can't add back more than what's there. So, you have to get it right as to where it is and how much it actually is. And then once you start getting to stuff that's really small, sometimes it's just not worth trying to figure out, it's not going to make that much of a difference in terms of the cash flow and just what the business is going to sell for.

[00:09:34]>> Yeah, exactly. Any crazy adback stories that you've seen that are like, "No, we're just not accepting that is not an adback." I saw a client who expensed building a deck on the side of his house through the P&L for the business. I think we were actually able to verify it because it was not anywhere close to a business expense. Um I actually have seen the rookie mistake of people like I said adding back credit cards. So at the bottom of the adbacks it says credit cards $15,000. It's like yeah but if it was an expense you can't add it back.

[00:10:06]And then sometimes if it is an expense it's really dropped the net profit. So you're double dipping in that case.

[00:10:13]>> I think also looking at one adback that you can use is family salaries. But again, you've got to figure out is person actually working in the business that they're not working in the business. Do you have to replace them?

[00:10:22]What's the fair market on them? So sometimes that gets a little dicey as to different family members working in the business. I don't know. You've probably seen some crazy stuff too that people run through their business, I would think.

[00:10:33]>> Yeah. All sorts of stuff. Especially if they do some sort of personal expense and then classify it as cost of goods.

[00:10:40]If they throw it into that line item, >> it's basically a done deal. The bank's not accepting it. It doesn't matter how legitimately personal it was.

[00:10:49]>> If you can't code it properly and have really good documentation, the bank's just not going to go for it.

[00:10:54]>> And that's why I think just like when we look at a business and we're looking at these expenses and we're evaluating the health of the business, the least adbacks the better, right? Like the least personal expenses. It's not bad to run personal expenses through the business. It's not bad to have some business dinners, some of your meals and entertainment, things like that. But when there's just like broad strokes taken, it's hard to verify and you just don't want that to be the majority of your sellers cash flow be through these adbacks. I think the other thing that we're also starting to look at is even if the owner is paying themselves a fair market wage through the business because when the lender goes to finance the loan, they're backing out a wage for the buyer, right? when they're doing their cash flow analysis. If the owner isn't extracting enough income out of the business when they go to back in a salary for the buyer, the numbers just may not work.

[00:11:41]>> Yeah. Here's an interesting one for you.

[00:11:44]Again, no right or wrong answer, but interesting. I'd be interested to see how you handle it. I had a business or we're in the process. It's actually in escrow right now. The business had a fairly large like speedboat that they bought through the business and they maintained it. They paid for the gas.

[00:12:03]Clearly, from one sense, it it was a construction company. It had nothing to do with the business, >> right?

[00:12:09]>> And it was personal. The seller argued this is 100% an adback. But when I dove into it a little bit more, they took contractors and people that would give them bids out on this boat a couple times a year. So, is that personal? Is it not personal? Do you add some of it back? Do you add all of it back? None of it back. It's interesting dynamic there where again, there's no right or wrong answer necessarily, but you have to be able to justify whatever position you're taking. Those are hard too. When you see like country club memberships, but they're taking clients out on the golf course. We see like sports tickets, right? They have Patriots tickets which are thousands of dollars, right? So, is that really an adback or are they taking customers to the game and that's part of the goodwill of the business? But then I guess I would argue if the Patriots tickets are part of the goodwill of the business, it should transfer with the business to the buyer. Buyer needs those. One other crazy story I remembered was years ago I had quite a large company under agreement. for $12 million and we were in due diligence with a private equity firm and we were actually in a meeting. We were doing like a larger financial diligence of quality of earnings and so we had the general ledger up on a screen and they were going through all the general ledger items and all we kept seeing was like Louis Vuitton, Gucci, like designer handbag after designer and his wife was buying like tons of stuff through the business like designer handbags shopping everything that he had never told me about. And this was like hundreds of thousands of dollars that added to his IBIDA and his cash flow. And I was like, why didn't you tell me there was like probably three to $500,000 in discretionary spending that your wife was spending that would have added to the value of my calculations, right? If you're looking at a multiple, I would have gotten you more money based on this additional stuff that was through the business, but he had just never thought about it and just never told me.

[00:13:59]>> Crazy. So, since you brought it up, let's talk about it. How do multiples differ with SDE versus IBIDA?

[00:14:07]>> So when we're looking at databases on business sales, they usually have two different multiples. One based on SD, one based on EBIDA. And typically I even multiple is going to be higher, right?

[00:14:17]So if you have a three times SD multiple, maybe it's a four times EBIDA multiple. But keep in mind the EBIDA number is lower than the SD number because you've have to bake in a replacement salary for the owners. So usually when you look at those two numbers, it comes out to usually the same overall value for the company, they should be pretty similar. We also look at ratios. So we'll look at percentage of EBIDA percentage of sales, what the ratio should be, cash flow as a percentage of sales, and we try to figure out whether the company's in ratio. So whether it's more profitable than other companies in its range, less profitable than other companies in its industry, and then we value based on that, if that makes sense.

[00:14:59]>> Yeah, that does. One of the biggest mistakes I see sometimes sellers make is they hear about a market multiple, they look at something online, chat GBT, and they apply SDE to an EVIDA multiple or vice versa, and it throws off their valuation.

[00:15:16]>> Yeah. they don't understand the difference or they're like sometimes they're basing it off of what a publicly traded company sold for. It sold for 25 30 times IBDA and they're like oh my business should sell for that and it doesn't work that way in smaller companies. So yeah, you have to be working with the right baseline numbers and understand it. And again, I think to your point to make it really simplify it is to get from SD to IBIDA, you really are just putting in a replacement salary for the owner, right? You're pulling out their salary, putting in a replacement, and that's how you get that Ebida mult or putting in a manager to replace them.

[00:15:50]Kind of the same thing.

[00:15:51]>> Yeah, exactly. Do you have a general framework that you like to use for testing if a deal is safe like DSCR or any other basic framework where before you take it to market, you've given yourself a gut check to say this is a good valuation, the market can support it, a lender can support it. What do you look at?

[00:16:10]>> Yeah. So, when we do our valuation for a client, we actually plug it into a price test. If it's under 5 million and we know it'll be financed with an SBA loan, we need to make sure that it's going to value. we put into a price test analysis and this spreadsheet actually we back out a fair market salary for the buyer.

[00:16:26]Now sometimes that's a little difficult to figure out but we know our area we know the salary that a lender may put in there. It's a little counterintuitive but even when they're working with SDE or cash flow in their analysis for coverage they put in a replacement salary for the buyer. So maybe it's $100,000 and then also it works in some working capital as well. So, if they're financing working capital, that also has to go into that analysis. And then it'll calculate what their loan payment is based on the current interest rate, a 10-year amortization, based on the SBA fees, and everything. And at the end, it spits out the debt service to cash flow ratio. And the ratio usually needs to be over 1.25. For some banks, they want 1.4.

[00:17:10]So, we always do that for deals that are going to be financed by an SBA loan. If it's not in range, we have to go back to the drawing board or go back to the client and say, "Look, even if you want this price, either you're gonna have to do some seller financing or something because a bank is not going to finance it at that price, it just won't cash flow."

[00:17:30]>> Yeah, I agree. I run that same test just to make sure. Yeah, exactly. I back up the data with market multiples and then I back into it from a DSCR standpoint.

[00:17:40]And to your point, we have to guess what the banks call a buyer's livable wage because that can affect the deal whether they need more money versus someone else who doesn't. But we can generally guess at that.

[00:17:51]>> But that's the real test. And to show some of these sellers, look, at your ideal asking price, the business doesn't even make enough money to pay someone a livable wage and service the debt. It's dead on arrival. So, we got to go back and either they got to recommmit to growing this business and make it more profitable and sell it in a couple years or come down to reality on price that is within a fair market multiple range and within an appropriate I usually tell my buyers 1.4 or above.

[00:18:19]>> That way there's a little bit of a buffer room so when things go slow, they can still be in a safe range.

[00:18:26]>> Yeah, I agree. It doesn't really matter if we think the business will sell for X if nobody can get financing on it. It really is a moot point and most buy I think sometimes sellers think someone's just going to pay cash for my business and maybe in some rare cases that happens but most people are going to leverage their money and go get an SBA loan and we know what the SBA is going to look for. I also encourage all of my brokers to go to a lender ahead of going to market, right? So, go to a lender, have them actually put a sheet together that first have them look at the deal, make sure that the price makes sense and that it's going to work and put together, I guess, a term sheet, but saying, "Okay, this is how the loan would be outlined. This is how much the buyer should put down. This is how much the debt service is going to be. Here's the SBA fees. This here's how much the working capital is." That way when we go to market, the buyer really has a good sense that they can afford this business, that they can finance it, and we've already proven that with a lender.

[00:19:15]And I feel like it just sends a lot a more strong message to our buyers.

[00:19:19]>> Yeah, absolutely. All right, maybe one more question here. How do you handle it? Maybe you don't get this as much as I get it being in Vegas, but how do you handle it or what do you say when you show up to someone and they the seller starts to learn about adbacks and what they are and they're like, "Oh, you know what? I've got an extra $100,000 that didn't actually hit the tax returns, but I can prove it. It's look at my POS system or look at my cash register. What do you come across that much or is it just me in Vegas?

[00:19:50]>> We come across it. Yep, we do. I basically say you can't have it both ways. You can't take it on the front end and on the back end. So, that's great you took that money, but then you can't expect to get that with the sale of your business. And keep in mind that $100,000 that maybe you didn't claim might be worth $300 or $400,000 on the back end in terms of multiple of cash flow. We will only go with what is on either a tax return or a profit and loss statement. We are not going to include that in our adbacks adjustments. If they want to have a conversation with the buyer on it, but the buyer is going to take it with a grain of salt. They can decide whether to believe it or not, and the bank's not going to be able to verify it. So again, we just we really can't use it. And we still do see it, but we try >> we try to avoid it as much as possible.

[00:20:36]We just don't want to say that there's money there if we really can't verify it.

[00:20:40]>> I always politely tell the seller, you got the benefit when you stole it from the IRS.

[00:20:46]>> They're not getting the value >> and they know they do this like awkward guilty laugh. They're like, okay, I get it.

[00:20:52]>> Yes. Exactly. So we do the same thing and have the same opinion on it and we see it less and less I would say but yeah absolutely and again you can tell me that wrote off XYZ through your business but unless it shows up on your general ledger unless it's pretty obvious. I remember I had clients that are like I go to Costco and I buy toilet paper for my daycare center and for my house. I'm like how am I supposed to go into your receipts and verify all the toilet paper you bought last year? I can't do that. It it doesn't make sense.

[00:21:18]So those kind of things we really just can't add back. They're just you really can't verify it.

[00:21:24]>> Yeah. Anything else that you think a buyer needs to know about SDE versus IBIDA based on this topic?

[00:21:33]>> I think it's really important for a buyer to work with a good CPA and we try to recommend CPAs to our buyers and I think CPAs that do M&A deals because sometimes you get CPAs that know how to tick and tie a tax return but they don't really understand what IBIDA is, what cash flow is, right? So like work with a CPA that does M&A deals who can explain this to you if you don't know. And then think of it as like a big pot, right? So if you're coming in, you're buying a business, how much cash is in that pot?

[00:22:02]If you're adding up everything of what the seller, you know, is taking out between salary, all the adbacks, and then put that pot aside and say, "Okay, now I need this salary and I need this and this is and and then calculate your debt service and then see what's left and make sure that you have enough cushion there." That's the best way to look at it, I think, is think of it as just like one big pot that then you're working with to then pay yourself and finance the business and still have some money of a cushion left over and then have a CPA helped to verify it for you to make sure that everything that was told to you was in the pot is actually there essentially.

[00:22:41]>> Yeah. I actually wrote a Facebook post this morning, scheduled to post tomorrow about that same thing. I called it owner's cash after debt service. That's like the key metric is exactly what you're talking about. Take out your owner salary, your debt, all that kind of stuff. What's actually left over?

[00:22:58]That's the key figure. So, as much as IBIDA is important, as much as SD is important, that figure also is really what at the end of the day is what drives the business and make sure that you've got enough to support the family as a buyer and service the debt and have some wiggle room for growth and periods where it might slow down.

[00:23:18]>> Yeah. Yeah. And I also try to explain to the seller, too, because we had this debate also on a seller's fair market rent adjustment. You have to put yourself in the buyer's shoes on the cost that a buyer is going to have, right? So, the fact that you're paying less rent for the property, like we had a deal that was on the market and they found out the landlord was going to up the rent, right? The minute that the lease was assigned, they're up the rent.

[00:23:37]I have to go back in now and do a new cash flow based on this new rent. You may not be paying that rent, but the buyer is going to have that rent. So, you have to make that adjustment. We see it with franchises, right? franchise fees. With a new franchise when you transfer it, they could be changing the fees. You might be grandfathered into different fees. So, anytime those things shift, it's going to shift the cash flow, the STE or the IBIDA because you have to think about how much money is there now for the buyer when they're taking over after all those adjustments are made. And I try to explain that to the seller and a lot of times they can understand that.

[00:24:09]>> Yeah, that's fantastic. Thanks for joining me. If anyone's out in your area, tell them where you're at, what area, and how do they get in contact with you?

[00:24:16]>> Absolutely. So, we are right outside of Boston. We're in need of Massachusetts.

[00:24:19]We cover pretty much a lot of the Northeast, but New England area. The company is called Baystate Businessbrokers. Our website is bstatebusinessbrokers.com and we have nine brokers in our office.

[00:24:32]So, we can service a variety of clients.

[00:24:34]I would say from about 2 million in revenue up to about 50 million in revenue. So, hopefully if you're in our area, we can be helpful to you. Nice.

[00:24:41]Thanks for joining me. I appreciate it.

[00:24:43]>> Thanks, Trent.