EBITDA/Normalized EBITDA, SDE, EV, VTB – What do they mean and why are they important?
February 28, 2020 · 3 mins
When buying or selling a business, you may encounter some terms that you may not be familiar with. The following are some common acronyms that you may encounter on the journey of buying or selling a business.
EBITDA
What is it?
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBITDA is used interchangeably with pre-tax operational cash flow. Normalizing EBITDA is the process of removing any non-recurring items and adjusting any items which are not recorded at fair market value. Some common examples of non-recurring items would be:
- insurance proceeds,
- non-arms length revenue or expenses, and
- one-time professional fees
Why is it important?
Calculating EBITDA is a common benchmark used to evaluate financial performance by comparing companies within the same industry. Normalized EBITDA is particularly important for lenders to measure a business’s ability to service debt and prospective purchasers to calculate potential returns on their investment.
SDE
What is it?
SDE stands for seller’s discretionary earnings, also known as owner’s free cash flow, is the net income of a business before deducting the owner’s salary, non-recurring items, depreciation, amortization, taxes, and interest. It is primarily used with smaller owner-operated businesses.
Why is it important?
Although not as commonly used as EBITDA, SDE is used as a benchmark by lenders and prospective purchasers to evaluate the business value. In an owner-operated business, the owner will use their discretion when taking a salary and that salary may not reflect what they would pay to a third-party manager. SDE is a helpful metric to understand total earnings available to a new owner.
EV
What is it?
EV stands for enterprise value. It’s a measure of a business’s total value if an investor were to purchase 100% of the shares of the company, debt free.
Why is it important?
EV is widely considered by industry experts to be the most accurate representation of a company’s value. It provides a precise valuation by adding back term debt and deducting excess cash. It also shows the value of a company’s assets, including intangibles, regardless of the debt/equity structure.
VTB
What is it?
VTB stands for Vendor Take Back. It’s used when the seller of a business provides a portion of the purchase price as a loan to the purchaser. It usually takes the form of a promissory note with agreed upon repayment terms, interest rate, and sometimes security.
Why is it important?
VTBs are commonly used to bridge the financing gap when the purchaser is having difficulty obtaining the necessary funds, between third-party lenders and their own equity, to purchase the vendor’s business. Third-party lenders like to see a VTB incorporated into a deal structure. It demonstrates that the previous owner is maintaining a commitment to the business and believes in the business’s continued success.
While there isn’t a “one size fits all” for VTB structures, it is common for a VTB to be between 5% and 15% of the total deal structure and to settle on terms that compensate the outgoing owner fairly for their risk. However, the VTB should not be so onerous that it prevents the business from growing. There needs to be balance between using cash flow generated to pay down debt, to reinvest in the business, and to provide returns for incoming owners.
If you still have questions about these common terms or any other topics pertaining to buying or selling a business, please contact Peter at (902) 368-2643 or peter.macswain@confederationgroup.ca
