EBITDA, SDE, or Free Cash Flow as the Valuation Multiple Targets
Whether you are an appraiser, business intermediary, or M&A expert, you will run into the terms listed above regularly. There is so much misuse of these terms in the business today it can become confusing.
Companies that have revenues less than 10 million dollars use business brokers or intermediaries to help them prepare and sell their existing company. These intermediaries usually use a cash flow term called SDE (seller discretionary earnings). This modified cash flow model does add soft owner benefits and one owners salary back into the earnings before interest, taxes, depreciation, and amortization. The reason for this is primarily that small business owners take liberties on salary, draw, and soft benefits such as life and health insurance that reduce taxable income by running these non-operational items through their profit and loss. It is certainly with in the rights of small business owners to do this providing they are following the IRS rules on the subject.
Valuation targets for the mergers and acquisitions market place, which we define as businesses that have revenue in excess of 10 million or have multiple shareholders, use EBITDA. When there are multiple shareholders or significant revenue and earnings it is important to use EBITDA as the multiple target. In these larger more complex business structures, the operator is not likely to be a sole owner. There should be no discretion in how expenses are running through the organization and we can now use a more pure form of earnings. EBITDA definition is the operating earnings of the company before interest, taxes, depreciation, and amortization. Because we are not adding back soft owner benefits and owner salary and burden, the EBITDA value should be lower than SDE on the same business. The EBITDA multiple is therefore higher than the SDE multiple on the same business.
Free Cash Flow is rarely used as a valuation multiple-target. This term is associated with a cash flow statement that an accountant or CPA uses to help with the cash flow of the business. A cash flow statement captures both the current operating results (income statement) and the accompanying changes in the balance sheet. What we discover upon closer look, is that a cash flow statement should always be used in conjunction with a valuation multiple because it gives the true existing cash flow remaining after all of the business uses and sources of cash flow are taken into consideration. EBITDA and SDE are only proxies for true Cash Flow. In a recent review of the three different definitions, each was deployed on the same business. While SDE was the highest at $600,000, EBITDA was lower at $450 implying that the owner took out $150,000 in salary and benefits, and true cash flow on the business was only $75,000. This implies there are other cash flow draws that do not show up on the income statement.
While SDE and EBITDA are the most commonly used multiple targets, free cash flow should also be used as a cross check on the cash flow definitions listed above. As always, contact a professional business intermediary who can assess your current business and provide valuable information about valuation targets.