Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / How to Value Owner Earning vs EBITDA in a Business Sale
Transcript
- Lucas: So there's a phrase that gets thrown around a lot in small business M&A, and I think it's worth really unpacking today: owner earnings. Because the EBITDA multiple that makes headlines — the eight times, the twelve times — it's usually built on a number that's a lot fuzzier than people think. Luna: You mean the difference between what a business reports and what it actually makes for an owner who's not there? Lucas: Exactly. And I've got a concrete case to anchor this on — a regional IT staffing firm that sold earlier this year. Publicly, the seller advertised 4.2 times EBITDA. But the buyer's real number, the one they based the offer on, was closer to 3.1 times seller's discretionary earnings, or SDE. That gap is the whole story. Luna: So the revenue was the same, but the earnings number they used was different. That's a big swing. Lucas: Right. The headline was 4.2 times reported EBITDA of about 1.1 million. But when the buyer's accountant started pulling apart the financials, they found the owner had been running a personal car lease through the business, paying his sister a salary for a marketing role that had never produced a single campaign, and expensing family holidays as 'client development trips.' Luna: Classic. And those are the addbacks that get presented as legitimate business expenses. Lucas: Some were legitimate, some were not. The buyer's team stripped out about two hundred and thirty thousand dollars a year in costs that would not continue under new ownership. That brings the true earnings down to roughly 870,000. Now, on an SDE basis, with the owner's salary added back, it's a different picture. But the point is, the multiple they actually paid was on the lower, stripped-down number. Luna: So 4.2 times EBITDA sounds great, but the actual deal was 3.1 times SDE. Why would a seller ever agree to that? Lucas: Because the buyer demanded it in the letter of intent. They had done the work upfront, and they priced the deal on what they believed the business would generate for them, not what the seller claimed it earned. And the seller, honestly, didn't have a lot of leverage because the business was heavily dependent on him. He was the rainmaker. Clients knew him personally. If he left, a big chunk of revenue was at risk. Luna: That's the owner dependence penalty we've talked about before. It showed up in the multiple. Lucas: It always does. But the interesting thing here is that the buyer didn't just lowball the multiple — they redefined the earnings base. And that's a move more buyers are using. They look at EBITDA, but they calculate SDE, and they anchor their offer to that. Luna: So let's get into the mechanics. EBITDA is earnings before interest, taxes, depreciation, and amortization. SDE is seller's discretionary earnings. What's the actual difference for a small business? Lucas: For a larger company, EBITDA is the standard because the owner is replaceable. For a small business, SDE adds back the owner's salary and perks, because the buyer is typically going to step in and run it themselves. So SDE is a truer measure of what a new owner-operator can expect to make. The problem is, sellers love to present the adjusted EBITDA with every possible addback, and buyers know that. Luna: And that's where the trust gap comes in. What's a legitimate addback versus a red flag? Lucas: Legitimate addbacks are one-time expenses, like a lawsuit settlement or a major equipment repair. They're also non-recurring costs that won't happen again. But when a seller starts adding back the owner's salary and then the salary of a spouse who does real work, that's when you have to be careful. In the IT staffing deal, the sister's salary was a red flag because she had no real role. But the owner also had a legitimate extra line item — a non-recurring legal fee that was a one-off. Luna: So how does a buyer actually verify these addbacks? I mean, you can't just take the seller's word for it. Lucas: You dig into the bank statements, the tax returns, and you ask for a detailed explanation of every single addback. In that deal, the buyer's accountant went back three years and compared the addbacks across years. If something appeared every year, it's not a one-time cost. And that's how they caught a few things — the car lease was consistent, but the 'client development trips' were only in year two. They had a conversation with the owner, and he admitted those were family vacations. Luna: It's like forensic accounting for small business. So what's the takeaway for a seller who wants to maximize their multiple? Should they just clean up their expenses before putting the business on the market? Lucas: Absolutely. I've seen sellers who do this well. There's a counter-example I like to use — a founder of a commercial construction supply company who, two years before selling, took a hard look at her books. She stopped paying her brother for a no-show consulting gig, she put her own salary at market rate, and she documented every discretionary expense. When she went to market, she presented an SDE that was defensible, and she sold at 7.2 times SDE. The buyer didn't even negotiate the earnings base. Luna: So she got a premium because her numbers were clean. That's the opposite of the IT staffing firm. Lucas: Exactly. And it's not just about the multiple — it's about the certainty of the deal. When a buyer sees clean financials, they're less likely to re-trade the price during due diligence. They're less likely to walk away. And in a competitive bidding process, clean books can be the difference between a signed LOI and a dead deal. Luna: I always think about that from the buyer's side. If I were looking at a business, I'd want to understand the owner earnings, not just the EBITDA. Because that's what I'm actually buying. Lucas: Right. And that's the mental shift for a lot of first-time buyers. You're not buying a financial statement; you're buying a stream of future cash flow. The question is, what will that cash flow be under your ownership, not what it was under the seller's. And that's why the concept of owner earnings is so central to small deal pricing. Luna: And this is something we talk about a lot on this show, and if you've been listening for a while, you know we love digging into these deal mechanics. And it's that kind of practical knowledge that we're trying to bring you every single week. And if these conversations have moved your work forward in any small way — maybe you're getting ready to sell, or you're thinking about buying — and you want to help us keep this podcast ad-free, you can support us by buying us a coffee at buy me a coffee dot com slash fexingo. It's a simple way to keep the lights on, and it's genuinely appreciated. Lucas: And we don't have any big corporate sponsors, so it's really listener support that keeps us going. So thanks for considering that. Luna: But back to the numbers. So we've got the IT staffing firm at 3.1 times SDE, and the construction supply company at 7.2 times SDE. What's the real difference? Is it just the clean books, or is there something else going on? Lucas: It's a combination. The construction company had a more diversified client base — no single client was more than eight percent of revenue. The IT firm had a concentration risk — its top two clients were forty percent of revenue. That's a huge red flag. Also, the construction company had a management team in place that could run the business without the owner for ninety days. The IT firm had no one who could even pitch a client without the owner on the call. Luna: So it's not just the earnings base; it's the risk profile around the business. The seller who can reduce risk gets the higher multiple. Lucas: Exactly. And that's the actionable takeaway. Sellers, if you want a higher multiple, you need to do three things. One, clean up your discretionary expenses. Two, reduce customer concentration. Three, build a management team that can operate without you. That's what buyers pay for. Luna: And for buyers, what's the one thing you should always ask for when you're looking at an offering memorandum? Lucas: Ask for the tax returns. Not the internal financial statements, but the actual tax returns. Because that's where the truth lives. A seller can present a beautiful P&L, but the tax return is what they filed with the IRS. It's not always perfect, but it's a lot harder to fudge. And then cross-reference that with the bank statements. If the revenue reported on the tax return doesn't match the deposits, you have a problem. Luna: That's a great practical tip. I'm going to remember that one. So let's wrap up with a bit of a thought experiment. If you're a seller and you're looking at your own business, how do you know if your EBITDA is inflated? Lucas: Ask yourself this: if you had to hand the business to a professional CEO tomorrow and you were never allowed to talk to them, would the business still generate the same earnings? If the answer is no, then your true owner earnings are lower than what the spreadsheet says. And that's the number a smart buyer is going to figure out anyway. Luna: So it's better to be honest with yourself upfront, because the buyer will find out eventually. Lucas: And that honesty is worth real money in a deal. The seller who presents clean, defensible numbers is the one who gets the competitive bidding and the high multiple. The seller who tries to inflate the base is the one who gets the lowball offer or the re-trade. It's that simple. Luna: And I think that's a great place to leave it. Thanks for listening, everyone. We'll see you next time.