What is DE and EBITDA & How to Calculate it

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.  

Note that the Federal Tax Return is always used for the past 3 years, and the internal P&L is used for the current Year to Date (YTD). Internal P&Ls are not used for the latter because they may have errors that have been corrected by the CPA on the tax returns. SBA lenders will only use the last 3 years of tax returns, plus the internal P&Ls for the interim year. Historical internal P&Ls are used as a reference for details only.

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 and non-operational expenses). These must be shown on the business tax return expense statements. Expenses not shown on the tax return cannot be added back
• + 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 on DE and Normalized EBITDA Add Backs

Typical Allowable Add-Backs for Seller’s Benefits & Expenses accepted by SBA Lenders and Valuation Analysists

What is included in DE or Normalized EBITDA

• 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.
• Owners’ benefit expenses must be part of a line item on the tax return, such as auto-truck expense or insurance, in which case, during Due Diligence, it’s on the Seller to provide documentation to prove this.
• 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.
• One time and “extraordinary” expenses can be added back, but they must truly be a non-recurring expense and not a normal operating expense. For example, Professional fees to the Seller’s attorney or CPA for preparing the business to sell, or Legal expenses for one-time litigation such are a one time unlawful termination or Worker’s comp would be an acceptable legal expense add-back, so long as there is not a history of this happening in the page. Another one-time expense could be remodeling a showroom or office.
• Travel expenses, Meals, and Entertainment are allowable add-backs so long as there is documentation to show that it is not a business expense.
• Owner’s and family health, medical dental, and life insurance are all allowable add-backs with documentation.

What’s NOT included in DE or Normalized EBITDA

• Ordinary operating expenses are not added back.
• 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.
• Expenses in “Office Expenses” are difficult to prove and SBA lenders to not accept add-backs in this expense category with out excellent documentation and rarely so.
• 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.
• Unreported “cash” is never 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.

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

DE and EBITDA FAQs