Taxable Income vs. SDE

June 18, 2022

by a searcher from The University of Chicago - Booth School of Business in Chicago, IL, USA

I have an LOI in place for a business and am starting the process of raising debt. I just got access to the company's tax returns. Taxable income is much, much lower than the SDE figures the company has provided, which isn't necessarily a surprise; However, what does concern me is that the relationship between sales and SDE varies wildly -- they made more sales in 2021 than 2020, for example, but while their taxable income indicated a strong profit in 2020, they reported a sizable tax loss in###-###-#### Their P&L trajectory is much closer, but even there the relationship doesn't fully make sense at first glance. I've asked the seller and broker to provide a reconciliation but want to do some calculations myself (and especially before engaging legal and a financial due diligence firm, just in case there's an obvious problem). Has anyone come across a reliable and concise primer on how to get to something that can credibly be called SDE from form 1120? While my GAAP accounting is ok, small business and tax accounting are still fairly new to me.

Thanks!

Reply by an investor
from University of Virginia in Richmond, VA, USA

I would start by converting the taxable income on the 1120 to EBITDA. You should be able to find the interest, deprecation, and amortization in the return. I assume this is an S-Corp and therefore won't have any tax on the return. Once you have EBITDA you'll certainly need the current owner's help figuring out what else has been added back to get to their estimate of SDE. What you will likely find is that they've added back all things that can be considered operator/owner compensation (salaries, benefits, travel, training, cell phone, home office expenses, vehicle, etc) and one-time expenses that they do not believe you'll experience as the new owner. That all needs to be examined closely to make sure the items added back to get SDE will not be expenses in the business once sold. Sometimes I've seen sellers broaden the definition of "discretionary" and include items such as senior managers in the business under the premise that the new owner could decide to operate in a different way or do that work themselves. These kinds of additions would be a red flag to me. Here is an article that you might find helpful. https://www.midstreet.com/blog/sellers-discretionary-earnings-explained-with-examples Hope this is helpful and good luck!

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

I am assuming this is not a retail business.
I first calculate SDE/EBITDA from the financials for multiple years. I rarely look at Tax Returns.
Financials have a lot more details than the tax returns. Tax return is most likely prepared by the CPA, and almost all the time they start with the financial statement provided by the seller to protect themselves. CPA should provide reconciliation if needed. There is always some difference between the FS and TR. However, if there is a big difference then possible reasons are:
1) FS may not expense CapX, TR would.
2) FS may be on accrual, TR on cash. (If so top line will be different in both).
3) During the year, COGS may be based on Std. Cost or a fixed % of sales. In TR, it is likely to be based on BInv+Purch- Ending Inv.
4) Many owners take out additional salary in TR at YE. They do not update the FS.
5) Sometimes (very rare) FS expenses loan payments, and CPA reverses it. Or the opposite. New debt is recognized as revenue in FS and CPA reverses it.
6) Customer deposit is very often recognized as revenue in FS. CPA would reverse it in TR, which would decrease income.
7) Many more.
I have "GAP" in my brain on "GAAP". Throw that s... out. It is has zero relevance in LMM M&A.
Happy to help to a fellow Booth.

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