Choosing the Right Measure of Cash Flow
When should you use SDE versus EBITDA to value your business? There are many differences to consider, including the fact that numerous adjustments are made when calculating both SDE and EBITDA. But, the major difference is that EBITDA does not include the owner’s salary.
EBITDA is used to value mid-sized businesses that can be run by an outside manager. In a small business, an owner would keep the owner’s salary, but in a mid-sized business, the new owner would need to pay a salary to a manager to run the business. It makes sense to use EBITDA when valuing mid-sized businesses because the majority of businesses in the middle market are purchased by other companies that must hire and pay a manager or CEO to run the business post-closing.
SDE is used to value small businesses in which the owner actively works in the business. In most small businesses, it’s difficult to distinguish between the profits of the business and the owner’s compensation. SDE addresses this problem by blending the profits of the business and the owner’s compensation into the one number called the seller’s discretionary earnings.
Let’s explore EBITDA and SDE in depth. I’ll explain which is more suitable for valuing your business, along with some other minor differences.
When To Use SDE
SDE is used to value small businesses in which the owner actively works in the business. Keep in mind that it’s often difficult to distinguish between the profits of the business and the owner’s compensation. Many business owners don’t pay themselves a salary and instead may take a “draw.” In other businesses, an owner may be paying themselves less than what they would have to pay an outside manager.
For example, they may pay themselves a $40,000 annual salary when a more appropriate salary for their role, based on market demand, would be $150,000 per year.
Additionally, many business owners deduct numerous personal expenses, or “perks,” through the business that would not be paid to an outside manager if they were running the business.
For example, a business may be paying for an owner’s personal vehicle, health club membership, vacation home, and personal travel expenses. It’s unlikely a business would pay for these perks for an outside manager.
SDE addresses this problem by blending the profits of the business and the owner’s compensation into one number. This is the total compensation that would be available to a new owner-operator of the business. In other words, this is what a new owner could potentially put in their pocket, regardless of how they decide to characterize the income – whether via perks, a salary, a draw, or dividends.
SDE makes sense when valuing a small owner-operated business because it’s difficult to distinguish business profits from the owner’s compensation in a small business. In most cases, distinguishing the two isn’t practical since most small business owners blur the line between “business” and “personal.” Calculating an appropriate manager’s salary for a small business is also more subjective than doing so for a mid-sized business.
SDE is normally used with businesses that have less than approximately $1 million in SDE. The SDE calculation is mainly used by business brokers since most business brokers sell businesses that are run by an owner-operator.
When To Use EBITDA
EBITDA is used to value mid-sized businesses that typically have an EBITDA of greater than $1 million per year and that can be run by an outside manager. If an owner-operator currently runs the business, the owner’s compensation is normalized to market levels.
For example, if the owner’s current salary is $500,000 per year, and the market rate is $200,000 per year, then the owner’s compensation is normalized to $200,000 per year.
If the current owner isn’t paid a salary, then an appropriate market-rate salary is deducted when calculating EBITDA. The same is true if the current owner or manager is underpaid. A market-rate salary for a manager or CEO is deducted to arrive at EBITDA. Regardless of what the current owner pays themselves, the owner’s compensation is normalized to current market levels, which range from $150,000 to $300,000 for most businesses in the lower middle market.
If a private equity group or company bought your business, they would need to hire a manager to run it, which is why the owner’s compensation is not added back. In a small business, an owner would keep the owner’s compensation, but in a mid-sized business, the new owner would need to pay a salary to a manager to run the business.
For example, if the SDE is $1 million, and a competitor bought the business and paid a manager $200,000 per year to run the business, their EBITDA would be $800,000 per year ($1,000,000 – $200,000 = $800,000).
It makes sense to use EBITDA when valuing mid-sized businesses because the majority of businesses in the middle market are purchased by other companies that must hire and pay a manager or CEO to run the business post-closing.
EBITDA is normally used with businesses that have more than about $1 million in EBITDA. EBITDA is mainly used by M&A advisors and investment bankers who specialize in selling businesses to private equity groups, competitors, and other companies. EBITDA is also used as a metric for public companies, but earnings, or simply net income, is more commonly used by publicly held companies.
EBITDA vs. Adjusted EBITDA
The term EBITDA is loosely used and often refers to “adjusted EBITDA.” Adjusted EBITDA includes additional adjustments that are not included when calculating EBITDA, similar to adjustments that are made to calculate SDE. Therefore, when discussing EBITDA, you need to clarify if you are referring to EBITDA or adjusted EBITDA. Most M&A advisors are referring to adjusted EBITDA when they mention EBITDA.
Some adjustments included in adjusted EBITDA but not standard EBITDA include:
- Non-operating income or expenses
- Non-recurring income or expenses
- Unrealized gains or losses
- Owner perks
SDE vs. EBITDA
Here is a chart summarizing the differences among SDE, EBITDA, and Adjusted EBITDA:
SDE vs. EBITDA vs. Adjusted EBITDA | |||
Adjustment | SDE | EBITDA | Adjusted EBITDA |
Interest (I) | Included | Included | Included |
Taxes (T) | Included | Included | Included |
Depreciation and Amortization (DA) | Included | Included | Included |
Owner’s Compensation | Included | Not Included | Not Included |
Non-Recurring Income and Expenses | Included | Not Included | Included |
Non-Operating Income and Expenses | Included | Not Included | Included |
Here is an example illustrating the differences:
SDE vs. EBITDA vs. Adjusted EBITDA | |||
Adjustment | SDE | EBITDA | Adjusted EBITDA |
Net Income | $200,000 | ||
Interest (I) | $100,000 | ||
Taxes (T) | $100,000 | ||
Depreciation and Amortization (DA) | $100,000 | ||
Owner’s Compensation | $300,000 | N/A | N/A |
Non-Recurring Income and Expenses | $100,000 | N/A | $100,000 |
Non-Operating Income and Expenses | $100,000 | N/A | $100,000 |
Total | $1,000,000 | $500,000 | $700,000 |
Are multiples the same for SDE and EBITDA?
If the multiples for the business were the same, it would seem that it would make sense to always value the business based on SDE. This is because SDE includes the owner’s salary and is therefore higher, and this would result in the highest value.
Unfortunately, this isn’t the case. Multiples of EBITDA are naturally higher than multiples of SDE for the simple reason that a business that’s run by a manager should sell for more than one in which the owner is working full-time. If the business is on the line, and either SDE or EBITDA could be used to value the business, the choice doesn’t usually impact value in the real world.
What if the value based on SDE is higher than the value based on a multiple of EBITDA? Again, it might seem that it would make sense to value the business based on a multiple of SDE. But businesses sold based on a multiple of EBITDA usually include working capital such as cash, inventory, accounts receivable, and accounts payable in the purchase price.
Let’s examine one final scenario that shows the difference of the multiple when it’s applied to EBITDA versus SDE.
EBITDA vs. SDE: Multiples vs. Business Value | ||
EBITDA | SDE | |
EBITDA | $750,000 | $750,000 |
Owner’s Compensation | N/A | + $500,000 |
Total EBITDA / SDE | $750,000 | $1,250,000 |
Multiple | x 4 | x 3 |
Value | $3,000,000 | $3,750,000 |
Working Capital | + $750,000 | + $0 |
Total Business Value | $3,750,000 | $3,750,000 |
Obviously, the math doesn’t always work out this perfectly. However, this example illustrates that the value is usually similar regardless of whether you use SDE or EBITDA.
Keep in mind that the two measures of cash flow concerning owner’s compensation represent the main difference between EBITDA and SDE. When valuing a business with less than $1 million in earnings, use SDE, where the owner’s compensation is included. When valuing a business with more than $1 million in earnings, use EBITDA, where the owner’s compensation is excluded. In each situation, you want to ensure that the value of the business is clearly laid out.
What should the valuation be based on?
In other words, which year’s EBITDA or SDE should I use? A valuation is normally based on the last full year’s EBITDA or SDE or the most recent twelve months – also called trailing twelve months, or TTM for short. In other cases, a weighted average may be used if results are inconsistent from year to year and business cycles are longer and unpredictable. Some value may also be placed on projected current-year EBITDA or SDE, if the growth rate is consistent and predictable. Some buyers may attempt to use an average of the last three years’ EBITDA or SDE, which can pull down the valuation if the business is growing from year to year.
How do you increase the value of your business?
While you shouldn’t ignore other factors, one of your most important objectives should be on increasing EBITDA or SDE. Every dollar increase in EBITDA or SDE increases the value of your business by its multiple.
For example, let’s say your business is likely to sell at a 4.0 multiple. If you increase your EBITDA by $100,000 per year, you will have increased the value of your business by $400,000 ($100,000 x 4.0 multiple = $400,000).
There are only two direct ways to increase EBITDA or SDE:
- Increase Sales:
- The easiest way to increase sales is to increase your prices because 100% of your price increases will fall to the bottom line. For example, if your company currently generates $10 million per year in revenue, and you increase pricing by 5%, then your EBITDA will increase by $500,000 per year ($10 million x 5% = $500,000), less any direct sales costs such as commissions. If your current EBITDA is $2 million, your EBITDA will increase by 25% (to $2.5 million from $2 million). In essence, a 5% rise in prices can increase your EBITDA by 25%.
- Other methods for increasing revenue primarily include creating new products or services, or selling more of your existing products and services. But be careful before engaging in risky product development or marketing campaigns if you plan on selling in the next few years. Conservative buyers will generally not allow you to make adjustments for any marketing campaigns or product launches that were unsuccessful when calculating EBITDA. I recommend sticking to low-risk methods of increasing your revenue if you plan on selling in the next three years, such as increasing your budget in predictable marketing campaigns with measurable returns. Avoid high-risk sales or marketing strategies like hiring a new sales manager or launching a new marketing campaign in which you have no experience. These strategies can drain cash flow, which decreases EBITDA and therefore decreases the value of your business.
- Decrease Expenses: Decreasing your expenses is often easier than increasing revenue. Doing so also has the advantage of having an immediate impact on EBITDA, and is less risky than attempting to increase revenue. The only caveat here is to not reduce expenses that the buyer would view as unfavorable – standard insurance premiums should be maintained, for example, as should normal inventory levels.
Another alternative for increasing the value of your business is to increase its growth rate so that “projected EBITDA/SDE” is used to value your business instead of “current year’s EBITDA/SDE.” The value of your business is normally based on its most recent 12-month EBITDA or SDE (trailing twelve months, or TTM). But, if you have demonstrated strong and consistent growth, you may be able to negotiate a price based on some measure of projected EBITDA or SDE.