SDE vs EBITDA vs Cash Flow
October 22, 2022 | Issue #73
Big Deal Small Business: SDE vs EBITDA vs Cash Flow
October 22, 2022 | Issue #73
It’s been 6+ weeks since my last newsletter post, so if you signed up in the intervening period, a quick reminder – I’m a PE investor turned self-funded searcher turned SMB operator.
As the “President” of a home services business, I’m a glorified general manager just trying to keep the wheels on the bus week-to-week (hence the random quiet periods between posts sometimes).
This newsletter chronicles my life as an SMB owner-operator, as well as topics related to search, SMB acquisitions, etc.
Today’s post is a longer one that gets into the weeds of defining profitability. That’s why I’m posting on a weekend. Read with a cup of coffee or a beer.
SDE vs EBITDA vs Cash Flow
On Twitter, on podcasts, in newsletters, etc...you'll hear talk about "earnings" or "multiples" when it comes to small business acquisitions.
There is rarely a clear definition applied to these words. So you need to know how to think about profitability & multiples in a consistent manner, or you risk misunderstanding what you're buying.
First, some definitions:
EBITDA = Earnings Before Interest, Taxes, Depreciation & Amortization
SDE = Seller Discretionary Earnings
Cash Flow....I'll get to this later.
Okay - let's dive in.
Seller's EBITDA
Note...I'm calling this "Seller's" EBITDA for a reason. More to come below.
The purpose of EBITDA is to compare businesses' operating performance on apples-to-apples basis by stripping out anything related to 1) capital structure or 2) capital intensity.
Capital Structure means how much debt the business has. A business with a lot of debt will have lower Net Income (because more interest expense) than a business with lower debt, even if the two core biz operations are equally profitable.
Why do we not care about Capital Structure? Because as a buyer, we're going to reset the whole capital structure anyway. Your cash flow depends on your acquisition capital structure, not the existing capital structure. When we get to cash flow, we will subtract these costs based on our capital structure.
Capital Intensity focuses on how much in assets (think equipment or R&D/IP) a business needs to generate its earnings. Depreciation of hard assets or amortization of intangible assets represents a cost related to capital intensity, so we add that back.
Why do we not care about Capital Intensity? We do care about it! The problem is Depreciation & Amortization are accounting concepts, not cash concepts, which can lead to them muddying the waters when comparing two businesses' core operating performance.
For example, let's say that 12 years ago, Business A bought $100K of heavy equipment with 20 years of life. Accounting/tax rules may allow that equipment to be depreciated to zero over 10 years, so $10K/year. Now Business A has no depreciation on P&L even though they are still using the assets.
On the other hand, Business B bought $100K of heavy equipment only 7 years ago, so they still depreciate at $10K/year for 3 more years.
They both have the same capital intensity (need $100K of original value equipment to generate their operating profit), but a function of time/accounting rules makes Business A's Net Income higher than Business B's Net Income. EBITDA normalizes for that. (Check the bonus section below though for a way to incorporate Capital Intensity back in a more fair way).
Lastly, a company's income tax burden is largely related to its capital intensity and capital structure as depreciation, amortization, and interest expense are all tax-deductible expenses. It can also vary based on each company's corporate structure, ownership profile, etc. Again, we care about taxes going forward (under our acquisition structure), not looking backward. So we add back incomes tax as well to make everything apples-to-apples.
Hopefully it is clear that EBITDA is nowhere close to Cash Flow. But it serves its purpose as a profitability metric of unlevered (read: no debt) operating performance regardless of age of assets, ownership structure, etc.
Bonus #1: PE firms commonly use EBITDA minus Maintenance Capex to incorporate Capital Intensity without the floating variable of time or accelerated depreciation quirks. Maintenance Capex is basically how much in Capital Expenditures do you need to spend on an annualized basis to maintain current profitability. (Distinct from capex required to generate growth).
In the case of Business A and B above, you could say they both need to spend $5K/year in maintenance capex if they need to buy $100K of equipment every 20 years. So you could add back their depreciation to get to EBITDA, then subtract $5K in maintenance capex.
Bonus #2: It is common for Sellers to include a number of "adjustments" or "addbacks" to EBITDA that represent unusual or one-time events. I've written a post exploring that concept, so check that out if you're curious.
Seller Discretionary Earnings
This is a concept that only exists in small business buying. It doesn't exist in most big business buying (i.e. middle market private equity, my former profession).
Why? Because most big businesses have distinct ownership & management teams. They are not the same person.
In PE, when we bought a business, the owner tossed us the keys and that was it. There was no change to payroll as the owners were generally purely financial owners, with no operating role or salary (or personal expenses running through the business).
SMB are different, with the owner usually playing a primary role in management. As a result, we use SDE as a way to compare SMBs.
For example, imagine two businesses in the same industry with $1M in revenue and $200K in EBITDA. Both have active owners. One of the owners takes a $200K salary, the other takes a $100K salary. Given they are owners, they are picking their salaries somewhat arbitrarily.
So which business is more profitable then? If you used EBITDA, they look the same. But in reality, one is generating $400K in SDE and the other is generating $300K in SDE (EBITDA + Owner Salary).
Other common addbacks from EBITDA to SDE include owner personal expenses (assuming you can verify them) or owner medical benefits.
In summary, the purpose of SDE is to compare SMBs regardless of how the owner chooses to take out their profits.
Buyer's EBITDA
Whoops, you thought I was going to cash flow next. Nope -- I called it Seller's EBITDA up there for a reason. Buyer's EBITDA is what we care about as buyers.
This is a CRUCIAL step in SMB buying (that doesn't existing in big business buying).
Put simply, there will be a bunch of new costs required to run this business as you replace the Seller. The two biggest are 1) replacing the functional roles the seller plays and 2) your own salary to run the business.
Think of Buyer's EBITDA as "Investor's EBITDA" -- what EBITDA are they buying. Even if you don't have investors, separate out the value of your time in the business when thinking about the investment returns for your money in the business.
For example, let's say the Seller is currently the GM and salesperson. You may be able to take over the GM role, but you'll have to hire a salesperson at $65K/year.
In that scenario, I would take SDE, lower it by your salary as GM (say $100K) and the salesperson salary of $65K/year. That's Buyer's EBITDA.
Note, other examples can include things like built-in rent raises...an SBA deal usually requires the landlord agreeing to a new 10-year lease extension. If they only agree to that in exchange for a $10K rent increase, you need to deduct that from SDE to get to Buyer's EBITDA as well.
Cash Flow
Finally, cash flow. There are a TON of ways to define cash flow, but I think of it in these three buckets:
Unlevered Free Cash Flow = cash flow generated by the business setting aside your debt
Levered Free Cash Flow = cash flow generated by the business including the cost of your debt
Distributable Free Cash Flow = cash flow available to the owner to take as a dividend or reinvest in the business
Here's the full walk from Net Income to each of those items:
How can you use these numbers to help understand the quality of a deal or the valuation of a business?
First, start with unlevered free cash flow yield. This is unlevered free cash flow divided by total purchase price (including transaction fees).
So if you're buying a business for $5 million with $250K in fees, your purchase price is $5.25 million. If your expected unlevered free cash flow is $700K, your yield is 13% ($700K/$5.25M).
In other words, setting aside any growth or leverage, the deal should return 13% / year just for holding the business steady.
Second, look at levered free cash flow yield. This is levered free cash flow divided by total equity invested into the deal.
In the above example, let's assume the $5.25 million price is funded using $1M in equity and $4.25M in debt. Let's say that debt carries $400K in interest expense, so your levered free cash flow is $300K. That means your levered free cash flow yield is 30% ($300K/$1M).
So if you never pay down your debt and just hold the business steady, you should generate a 30% annualized return.
Lastly, distributable free cash flow just gives you a sense for how much money you'll have left to reinvest in the business or take out. Let's say you have a grand business plan to grow at 20% per year. Well, that probably takes investment in the form of working capital or capital expenditures. Distributable free cash flow helps you assess how realistic your growth plans really are, as that's your cash available to invest in growth.
Tying It All Together
Why does any of this matter?
Because if you hear someone say they bought a business for 4.5x, you have no idea if that's a good deal or not.
If they bought a biz for 4.5x SDE of $1M (so $4.5M price), but there's like $400K in replacement costs to replace the seller, that means EBITDA is $600K. That means they paid 7.5x EBITDA! On the other hand, if they paid 4.5x Buyer's EBITDA...that's pretty solid.
How do you know that? Because the 7.5x Buyer's EBITDA deal will have a way lower unlevered free cash flow yield than the 4.5x Buyer's EBITDA deal.
Similarly, you may see lots of self-funded deals that boast 80%+ equity returns. These are LEVERED returns. That doesn't mean it's a good deal, it's just a function of the massive leverage allowable by the SBA 7(a) loan program. It's usually cleaner to compare deals on an unlevered yield basis, and then compare how much debt you can prudently put on each deal.
Knowing these definitions of profitability like the back of your hand is a core muscle of being a disciplined business acquirer. You'll develop a sixth sense for whether or not a deal makes sense when these profitability concepts are hardcoded into your brain.
Conclusion
That was a lot...props to you if you read through the end. I hope that all made sense and was reasonably helpful. If you have questions, feel free to hit reply or find me on Twitter.
Until next time!
Best,
Guesswork Investing