The most common path an acquisition entrepreneur takes when they learn about the possibility to buy a business, they start digesting the available information on the topic. Regardless of the amount of information consumed, there seems to be a common question for all beginners when reviewing deals. How much will I actually make as the owner?
This is common and completely understandable because there are so many terms tossed around that make it difficult to know exactly what the net income will be.
The Basics: Components of an Income Statement
Understanding the core components of an income statement or profit and loss (P&L) statement serves as a necessary foundation. These are the primary components of an income/P&L statement:
Top line revenue
– Cost of goods sold
– Operating expenses
Bottom line net income
The Basics: Non-Cash Expenses
If you buy a big piece of infrastructure in year one, you can’t expense all of this on the P&L to claim a loss.
Instead, you take the cost and spread it out over a number of years, depending on what was purchased. This is called depreciation or amortization, depending on if it’s a hard asset or an intangible asset.
Another example, you build a new website. It’s a really awesome website and it’s $100,000. Rather than taking all of that as an operating expense in one year, I’m going to amortize it over 10 years. That means there’s a $10,000 expense every year on the P&L statement.
The thing is that each one of these years, I’m not actually paying $10,000. It’s an illusion of money that was spent previously but is being captured in future years. This depreciation and amortization model is called a non-cash expense.
John Malone came up with the concept of EBITDA because he was using acquisitions to drive the growth of his company. He was also using it to increase the amount of non-cash expenses that the company had because you get to depreciate the entire cost of a business. He was depreciating the additional acquisitions, which was increasing the amount of cash flow but the public markets at that time only understood earnings per share. This was the only way they told time – what’s the net income versus the amount of shares.
He came up with a term EBITDA which stands for Earnings Before Interest, Taxes, Depreciation and Amortization which is used in publicly traded markets to compare one company to another – an apples-to-apples situation.
The most common challenge for first time acquisition entrepreneurs is that EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and SDE (Seller Discretionary Earnings) as used as if they are interchangeable but they’re very different.
So, let’s unpack the different terms for different earnings amounts and when each one is typically used.
If you have two different cable companies (John Mullins and TCI), one of them has an EBITDA of $100 and the other an EBITDA of $150 – which one is better?
You know that the $150 is better but you can’t exactly see that in earnings per share or a net income, especially if net income is buried in a lot of non-cash expenses.
As a result, EBITDA is the gold standard a publicly traded company.
Next, a term called adjusted EBITDA was developed. The biggest question around this concept was, “what are you adjusting?”.
Adjusted EBITDA accounts for a number of add backs and one-time expenses to try to illustrate the actual EBITDA for a new owner.
Let’s pretend that there was a $100,000 legal battle underway. Once it is settled and done, the expense will not occur again. So that expense becomes an add back. These professional services was a discretionary spend due to a unique situation. If there was a big capital expenditure that took place that was a one-time event that will not need to be redone in the future, then that capital expenditure might get added back in.
Add backs are important because it allows the adjusted EBITDA to really reflect the earnings available to an owner. Adjusted EBITDA includes common market-rate associated with having a non-owner leader in place.
Adjusted EBITDA is most common for an absentee owner or a strategic acquirer because they won’t be operating it. This term is most common in deals over $10 million in transaction value. It can be used at any point based on the transaction team involved and what language they’re use to using; however, it’s typically most appropriate for larger transactions.
Transactions that are sub-$5 million in transaction value, the market tends to use the term seller discretionary earnings (SDE).
The concept behind seller’s discretionary earnings is how much money is cashflowing to this company’s owner.
The term seller discretionary earning refers to the amount of money that an owner will have to allocate appropriately to run his business. This amount will include expenses like a salary, money to reinvest into the business, money to pay down principal and interest payments, etc.
This is the total amount of money available to an owner to allocate as they see fit.
EBITDA vs. Adjusted EBITDA vs. SDE
EBITDA is the financial metric used at publicly traded company level.
Adjusted EBITDA is more in the private middle markets.
SDE is really the total cashflow available to an owner for all management decisions to operate.
If the acquisition entrepreneur is hiring an operations manager, then the net income value is Adjusted EBITDA.
These are the three biggest terms for earnings and how people use them typically depending on size.
As you get more comfortable in the market, you’ll start to see that each of these earns different multiples and valuations.
Hopefully that gives clarity and insight into the different units of measure – all trying to tackle the same thing.
“What is the cashflow that this entity is generating?”
If you plan on buying a business in the next 12 months, please consider applying to the Acquisition Lab. We have a vetted group of buyers and a do-it-with-you buy-side advisory service. Please feel free to apply and get world-class education, support from our team of advisors, and a suite of tools and a vetted community to help you succeed in that first acquisition or in implementing a grow-through-acquisition process.