Definition
Normalised earnings are a business's profits restated to show what it would earn in an ordinary year under new ownership. Normalisation removes one-off income and costs, strips out the owner's personal spending and corrects costs that are not at market rates, such as family members paid too little or rent paid to the owner. SDE and adjusted EBITDA are both forms of normalised earnings. Adjustments can reduce profit as well as increase it.
Seller's discretionary earnings (SDE)
Seller's discretionary earnings is the yearly financial benefit a business gives one full-time working owner, before financing costs, non-cash charges and one-off spending.
Adjusted EBITDA is EBITDA after normalising adjustments, showing what a business would earn with a paid manager in the owner's seat. Larger small-business deals are usually priced on it.
Worked example
Pennywhistle Dental Laboratory is a fictional UK business with profit before tax of £400,000.
- Add £30,000 for legal fees on a dispute that has been settled, supported by invoices.
- Add £20,000 for the owner's personal car and phone run through the business.
- Deduct £40,000 because the owner's spouse keeps the books unpaid, and a bookkeeper would cost that much.
- Deduct £25,000 because the business rents its premises from the owner at £25,000 a year below the market rent.
Normalised earnings are £400,000 + £30,000 + £20,000 minus £40,000 minus £25,000, which is £385,000.
Net profit before tax is what a business earns after all its costs, including interest and depreciation, but before tax on its profits. It is the starting point for SDE and EBITDA.
Why buyers care
A multiple is applied to normalised earnings, so each adjustment is multiplied too. At a multiple of three, a £50,000 add-back that does not hold up adds £150,000 to the price.
Sellers tend to present the upward adjustments and leave out the downward ones. Ask for evidence behind each item, and look for costs a new owner will face that the current owner does not. Loupe's valuation tool asks you to include only one-off or discretionary costs you can evidence, and sets out the build-up under "Show the maths".
Add-backs are costs added back to reported profit to show what a business would earn under a new owner. They raise SDE and adjusted EBITDA, so each one needs evidence.