Income, assets and the market are the three most popular approaches used to value a business. This article will focus on the different types of income used within the income methodology. Under the income approach, companies are valued based on the profit the company generates. Buyers are more concerned with the amount of revenue they would have available if they acquired the business. Net revenue, reported in profit and loss statements for tax purposes, does not represent the true earnings of the business based on non-cash, discretionary, and non-recurring items spent by the business owner. Profits are intentionally kept low to achieve the goal of mitigating income taxes. Therefore, to determine the true earning capacity of the business, the profit and loss statements must be restated during the valuation process to arrive at SDE or EBITDA. The recast standardizes (or normalizes) business earnings through the exclusion of discretionary, non-recurring, and variable items, allowing for an accurate and objective comparison between two or more businesses. The value of the business is then calculated by applying a multiple, consistent with the industry and a weighting of the factors that affect the business, to the amount of SDE or EBITDA.

Seller Discretionary Earnings (SDE):

Seller discretionary earnings (also known as discretionary earnings) are typically used for businesses with less than $1 million in adjusted earnings. These businesses generally have the owner operating and receiving a salary through the business. With these small businesses, it is important to determine what the ‘owner’s profit’ is compared to the ‘profit’ of the business. This is achieved through a series of P&L adjustments called ‘add-backs’ that are made to pre-tax trading profits. In certain circumstances, there are negative surcharges, such as in the case of a business owning the building where the owner pays himself below market rent or a family employee performing a critical business function who is paid below market wages. From the market. In both cases, an adjustment is made to normalize the expense to fair market value.

The most common adjustments in the recasting process are the following:

• Add an owner’s total compensation

– Salary

– Payroll taxes

-Insurance

– 401K / Retirement Contributions

– Benefits (Club Memberships, etc.)

• Add non-cash expenses

– Depreciation

– Amortization

• Additional interest expenses

• Add discretionary expenses (not necessary in the operation of the business)

– Owner’s vehicles

– Travel and entertainment

– Non-Essential Phones

– Donations

• Add non-recurring expenses

– Penalties/Fines

– Attorney fees (for example, related to the sale of businesses)

• Adjust rent/lease to FMV

Earnings before interest taxes depreciation amortization (EBITDA):

Larger companies, typically with adjusted revenues greater than $1 million, use EBITDA to define company earnings. In most cases, the owner/investor does not actively direct the operations of the business and must pay a general manager to perform that function. Therefore, the EBITDA calculation will differ from SDE as it includes manager compensation in the earnings calculation as an expense. EBITDA is a non-GAAP measure used to determine profitability and make comparisons across companies and industries because it removes the effects of accounting and financial decisions. An easy way to determine EBITDA is to subtract SDE owner compensation and benefits. While the EBITDA number will be lower than SDE, the multiple used in valuation is typically higher, often 2-2.5 times the SDE multiple. Therefore, as might be expected, the market value of the same business calculated using either method should be similar. If not, a determination must be made as to why and which (or what other method(s)).