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The True Value of SDE As a Valuation Metric, & Other Acronyms

By Jason Yelowitz
Last Updated on | Reading Time: 4 minutes

As with many industries, the business of buying and selling websites can involve sorting out a bowl or two of “alphabet soup” in the form of acronyms and initialisms. When you’re reviewing marketing materials for available websites, you may notice terms such as “EBITDA,” “SDE”, and “ODI” floating throughout the copy.

What do these terms mean, and why are they so important to you as a purchaser? Let’s start with a few basic definitions:

Earnest Before Interest, Taxes, Depreciation, & Amortization (EBITDA)

As its name implies, this value represents profits taken before interest, taxes, depreciation, and amortization. EBITDA can be used as a multiple for valuing the business on its own, or added to the current owner’s salary and benefits to produce a value for SDE.

Seller’s Discretionary Earnings (SDE)

A seller’s discretionary earnings are profits taken before taxes, interest, non-cash expenses, the owner’s benefits, one-time investments, and any non-related income or expenses. This is the common metric used for most Internet and small business listings. The goal is to determine what the owner “really” makes.

We see many examples where owners write off personal items (such as vehicles, their own health insurance, cell phones, etc.) to the business. But any reasonable buyer will understand these expenses are discretionary (the “D” in “SDE”) and don’t really make a difference to the underlying value of the business assets.

Owner’s Discretionary Income (ODI)

Another term for SDE.

Establishing a Baseline

While it’s beneficial to business owners to reduce their taxable income by charging certain expenses to the company, doing so can warp the actual SDE of a business. Normalizing the company’s income and expenses reduces confusion and can more clearly illustrate the earning power of a business to buyers.

We focus on SDE (and EBITDA) during the recasting (or normalization) process in order to get closer to a solid baseline value that tells us how much a business actually earned for the seller, and what it will hopefully earn for the buyer once the transaction is complete.

To develop a clear SDE, we have to start with the EBITDA, which provides a firm foundation before any add-backs. Beginning with the EBITDA, we then add:

  • The Owner’s (or Owners’) compensation, including benefits
  • Add-back values for personal items, e.g. personal travel or vehicles
  • Add-back values for one-time expenses, e.g. new computers, website redesign, etc.

Each of these adjustments are made to provide a more accurate picture of the potential income available to the buyer. We wrote about this in more detail here.

A Sample Income Statement

Some expenses are likely one-time events—for example, the add-back under “Office Expenses” could have been for new computers, furniture, or other hardware that won’t be a regular spend for the company—while others, such as the owners’ salary and benefits, can be adjusted at your discretion. At QLB, we show our work and will gladly explain and justify any add-backs used to arrive at SDE.

The add-back which is most contentious is the owner’s salary. Buyers will sometimes complain that it’s not a legitimate add-back because they’ll need someone to run the day-to-day operation. But think of it this way, if a business earns $100,000 in EBITDA, the seller can choose to pay himself a salary of $1 per year or $100,000 per year. In the latter example, if he paid himself $100,000 per year, the business would have zero earnings and applying a multiple that would lead to a business value of zero. Right away we can see that doesn’t make sense.

“Sure, but I still need someone to run things,” a buyer might counter. Well, maybe—and maybe not. The multiples on SDE for Internet businesses generally range from 2x to 4x in 2014. If you had someone running all the operations for you, and you were completely absent, the implied cash-on-cash return would range from 25% ROI to 50% ROI. Wow! That’s pretty phenomenal, and certainly beats the expected returns from stocks, bonds, real estate or virtually any other asset class.

Given the low multiples, it’s not ridiculous for a buyer to expect to do a little work to run a business or to pay for help out of the cash flow once they buy it. (All that said, we certainly do get some listings with these same multiples, but a very low workload!)

This is the convention adopted by virtually all business brokers and lenders, and it’s a legitimate one. The fact that you may have some expenses to bring on additional help if you don’t have the time or the skills to replace the owner yourself is reflected in the multiples on the listings.

You can always buy a truly passive business by purchasing stock of a publicly-traded company. The multiples in the stock market usually hover around 15x, but can climb nearly to infinity if you’re looking at WhatsApp or some of the other ridiculous Internet businesses out there.

Applying The SDE To Your Calculations

When making your calculations, remember that every buyer is unique, and you’ll have your own set of circumstances, expectations, and goals that will adjust the final earnings value. For example, if you plan to reduce staff by farming out certain roles (or even all of them), you’ll need to adjust the SDE to account for the cost of the contract services you’ll need to engage to replace the work currently done by staff or the owner.

But remember, the potential cost involved is already reflected in the multiples of SDE in the original asking price. If (to use another example) the company needs a new website (or equipment, or licenses, etc.) in order to function, you must factor in this one-time expense as well.

Remember, it’s up to the buyer to perform his or her own due diligence. The broker works off the numbers provided by the seller, but does not perform due diligence on their accuracy.

Featured image photo credit: Jorge Franganillo via photopin cc

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