Discretionary Earnings or DE and EBITDA are earnings terms used frequently in business sales, but what exactly do these figures mean, and how are they calculated?
For additional information on using Earnings Multiples to value a business, see our Blog “How to Value a Business Using Earnings Multiples”.
Discretionary Earnings Calculation
To calculate Discretionary Earnings (DE), start with Net Profit shown on Federal Tax Return, then add Interest, Depreciation, and Amortization plus owner’s benefits and expenses as shown below.
Net Profit (Federal Tax Return)
- + Interest Expense
- + Depreciation
- + Amortization
- + Owner’s compensation (from W2 salary on tax return)*
- + Owner’s benefits such as auto, health insurance, travel/entertainment, and other expenses (non-business expenses and shown on the business tax return expense statements)
- + One-Time & Non-Recurring or Unusual Expenses. These are added back if they are a one-time extraordinary expense.
= Discretionary Earnings, aka DE or SDE (Seller’s Discretionary Earnings)
IMPORTANT NOTES – What’s NOT included in DE or Normalized EBITDA
- Distributions are NOT an add-back for determining Discretionary Earnings.
- Distributions are a Balance Sheet transaction and not an expense in the business. Distributions are from the Net Profit of the business, and thus adding back Distributions is effectively double-counting.
- Expenses that are not shown on the business tax return and statements are not an add-back.
- Often, owner’s benefit expenses are part of a line item, such as auto-truck expense or insurance, in which case, during Due Diligence, it’s on the Seller to provide documentation to prove this.
- SBA lenders do not generally accept any add-backs in COGS because they are very difficult to distinguish from normal operating expenses. Some business brokers may include these add-backs if they are well documented, but be aware that your SBA lender will not likely count COGS add-backs toward DE or Normalized EBITDA.
- Unreported “cash” is never part added to the tax return revenue figure, and SBA lenders will not accept this as additional revenue. In some cases, with small main-street businesses, the broker may add cash to the revenue figure, but this is not the customary practice for calculating DE or EBITDA. It’s up to the buyer if they want to accept cash as part of the revenue.
- DE is modeled as a single owner-operator. If there are multiple owners or partners working in the business, the practice is to add back all of the W2 salaries and then have a negative add-back (additional expense), replacing all but one partner with market-rate salaries for the positions they hold. Partners that are passive and not working in the business are simply added back with no replacement salary.
- Family members who are not owners are treated similarly to the above. If they are actively working in the business and intend to leave after the sale, then their salaries are added back with a market rate replacement salary to offset the add-back.
Normalized EBITDA Calculation
The simplest way to calculate Normalized EBITDA is to start with DE (Discretionary Earnings) and subtract the market value replacement salary for a manager to run the business. Normalized EBITDA is essentially the earnings of the business under an absentee owner business model.
To calculate Normalized EBITDA from scratch you would do the following:
Net Profit (Federal Tax Return)
- + Interest Expense
- + Depreciation
- + Amortization
- + Owner’s compensation (from tax return)
- + Owner’s benefits such as auto, health insurance, travel/entertainment, and other expenses (non-business expenses and included on the tax return)
- + One Time & Non-Recurring or Unusual Expenses. These are added back if they are a one-time extraordinary expense.
- – Replacement Salary at market value for a Manager to replace the owner. (Note that most SBA lenders use $100,000 to $150,000 for a replacement salary on business prequalifications)
= Normalized EBITDA
What’s the Difference Between EBITDA and DE?
EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) is a common term for earnings typically used for very large companies and Publicly Traded companies. When earnings are reported on the news for large corporations they are typically referring to EBITDA and simply call it “earnings” for simplicity. EBITDA is used to measure earnings because it adds back non cash expenses such as Depreciation and Amortization and also adds back Interest and Taxes to arrive at a normalized cash flow for the company.
EBITDA is also used for privately held mid-sized companies, but it requires some adjustments to reflect the actual EBITDA. Most privately held companies have owners’ compensation and benefits included in the company expenses. If one calculates EBITDA by simply adding back Interest, Taxes, Depreciation, and Amortization the owner’s expenses have not been adjusted out of the expenses. For privately held companies, a Normalized or Adjusted EBITDA is used (see below) where the owner’s benefits and expenses are added back, and then a replacement salary for the owner is subtracted. Normalized EBITDA reflects the earnings of the company with a professional manager (eg. a GM or President) operating the company. Normalized EBITDA is most commonly used for businesses with at least $5 million to $10 million in sales and above.
For businesses under $5 million in sales, Discretionary Earnings (DE) is the most common earnings metric used. DE is very similar to EBITDA except that with DE, the owner’s salary and expenses are added back to reflect the total economic benefit the owner derives from the company. DE assumes the company is operated and run by the owner. The DE calculation adds back the owner’s benefits and expenses that are not business essential or are an economic benefit to the owner, which is another form of compensation.