Cash flow normalization is done with the intention of identifying Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) or Seller’s Discretionary Earnings (SDE). These differing measures are not interchangeable, but are used by different classes of buyers for different categories of acquisition.
Free cash flow is an important measure when calculating the value and price for any business. It is the amount theoretically available for servicing acquisition debt, working capital, return on investment for any cash outlay in the acquisition, and future expansion.
Cash Flow Measures
EBITDA establishes free cash flow as a measurement for most mid-market businesses. It evens out the differences in earnings caused by various tax jurisdictions. In the United States, there is federal income tax at the corporate level, but many states have additional income taxes, and in some cases, even smaller jurisdictions like cities may have their own income tax. These obviously impact the profitability of a company and could distort a buyer’s impression of its profitability.
EBITDA calculations do not include the owner’s earnings, since the companies being examined are more likely to be acquired by investors who would replace the owner with a management executive.
SDE is the measurement used to illustrate the sum total of financial benefits available to the owner-operator of a business. It assumes that the owner is running the company on a day-to-day basis. SDE encompasses not only salary, bonuses, and distributions, but includes insurance and other benefits such as a company-paid vehicle.
A simple way to put it is that EBITDA is the cash flow available for a return on investment. SDE is the cash flow available for a return on the owner’s labor.
Making Adjustments
In the SDE calculations, there are two places where there is often an adjustment of expenses to market. The first is for a family member employed in the business or partners who intend to leave simultaneously with the principal owner.
In many instances, family members are paid according to their needs or the needs of the business instead of at a market rate for the position. With family members who are “underpaid” adjusting to the market rate will have the effect of reducing the cash flow available in the business. This reflects the fact that the family member or partner will have to be replaced by someone who is unlikely to work for a below-market salary.
The opposite is of course true for family members or partners who are overpaid. Reducing their compensation to a fair market rate will add to the discretionary cash flow of the business.
A second area of adjustment is when the owner of the company also owns the real estate that the company operates in. Again, the rents paid on the real estate often reflect the owner’s objectives more than they do the practical reality of the local real estate market.
A company that is underpaying rent is having its bottom line shored up by the reduced income to the real estate entity.
Overpayment of rent requires the owner to make a decision. If they expect the same rent from a new tenant, the profitability of the business as presented to a prospective buyer will be lower. Considering that most transactions involve a multiple of cash flows, you can usually point out to the owner that trying to maintain a higher rent is not in their interest as the seller of the company. Adjusting the rent to a market rate increases the cash flow of the company and presumably the basis for an evaluation multiple.
Which Cash Flow is “Right?”
The decision of whether to use EBITDA or SDE when calculating cash flow is dependent largely on the size of the client’s business. If the company has cash flow in excess of $1 million annually or is large enough to be a likely target for professional buyers, EBITDA is the appropriate measurement for cash flow.
If the company is going to be purchased by family members, employees, or another entrepreneur and has a cash flow of less than $700,000, SDE is almost always a more appropriate measurement.
Which cash flow is used is a situational decision and may change if different classes of buyers are being engaged.
