Should I use SDE or EBITDA to Value a Business?

What’s the difference between SDE (seller’s discretionary earnings) and EBITDA (earnings before interest, taxes, depreciation, and amortization)? Should I use SDE or EBITDA to value my business?

SDE and EBITDA are two different ways of measuring the profit or cash flow of a business. The main difference is:

• SDE is the primary measure of cash flow used to value small businesses and includes the owner’s compensation as an adjustment.
• EBITDA is the primary measure of cash flow used to value mid to large-sized businesses and does not include the owner’s salary as an adjustment.

Numerous adjustments are made when calculating both SDE and EBITDA. For example, interest, taxes, depreciation, and amortization are added back when calculating both SDE and EBITDA and many of these adjustments are similar when calculating both. However, the major difference is that EBITDA does not include the owner’s compensation.

The purpose of calculating SDE and EBITDA is so businesses can be compared to one another on an apples-to-apples basis. To facilitate a uniform comparison, the adjustments made when calculating SDE and EBITDA should be consistently applied.

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 one number called the “seller’s discretionary earnings” — SDE.

EBITDA is used to value mid-sized businesses (greater than $1 million in EBITDA) that can be run by an outside manager. 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. 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.

Let’s explore SDE and EBITDA in-depth, along with some other minor differences.

Table of Contents

• When to Use SDE
• When to Use EBITDA
• SDE vs. EBITDA
• Are Multiples the Same for SDE and EBITDA?
• Summary

When to Use SDE

SDE is defined by the International Business Brokers Association (IBBA) as the earnings of a business prior to:

• Interest expense or income (the “I” in EBITDA), plus
• Taxes (income taxes, the “T” in EBITDA), plus
• Depreciation and amortization (the “D” and “A” in EBITDA), plus
• Non-recurring income and expenses, plus
• Non-operating income and expenses, plus
• Owner’s total compensation for one owner, after adjusting the compensation of all other owners to market value.

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. Many business owners do not 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 $100,000 per year.

Additionally, many business owners deduct numerous personal expenses (“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 called the “seller’s discretionary earnings” — SDE. 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 to use 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 about $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 defined as earnings (E) before (B):

• Interest (I)
• Taxes (T)
• Depreciation (D)
• Amortization (A)

EBITDA is used to value mid-sized businesses (greater than $1 million in EBITDA) 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 is not 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 averages from $150,000 to $300,000 for most businesses in the lower middle market.

If a private equity group or company bought a 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 $1,000,000, 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 should 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 between SDE, EBITDA, and adjusted EBITDA:

Following is an example illustrating the differences:

Are Multiples the Same for SDE and EBITDA?

In the example above, 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 because this would result in the highest value.

Unfortunately, this is not the case. Multiples of EBITDA are naturally higher than multiples of SDE for the simple reason that a business that is 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 does not usually impact value. Here is an example to illustrate. This example is from the same business, but we are valuing the business based on both SDE and EBITDA:

• $1,000,000 SDE x 3.0 multiple = $3,000,000 asking price
• $750,000 EBITDA x 4.0 multiple = $3,000,000 asking price

In this example, we assumed an owner’s compensation of $250,000 per year. This resulted in SDE of $1,000,000 and EBITDA of $750,000 ($1,000,000 – $250,000 = $750,000). In this example, the value we arrived at was identical for both methods.

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 (cash, inventory, accounts receivable, accounts payable) in the purchase price. Let’s examine one final scenario that shows the difference of the multiple when it is applied to EBITDA versus SDE.

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.

Summary

Keep in mind that the two measures of cash flow concerning owner’s compensation represent the main difference between SDE and EBITDA. 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.