Key Takeaways

• SDE (Seller’s Discretionary Earnings) is ideal for valuing owner-operated businesses where the owner’s salary and perks are part of the calculation.
• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is better suited for larger, mid-sized businesses where the owner’s compensation is excluded.
• The Main Difference: SDE includes the owner’s compensation and perks, while EBITDA does not, allowing each metric to serve different buyer needs.
• Buyer Expectations: Buyers seeking passive investments or larger companies often prefer EBITDA, while individual buyers look at SDE.
• Choosing the right metric enhances valuation transparency and helps attract the right type of buyer.

What Are SDE and EBITDA in Business Valuation?

SDE and EBITDA are both cash flow metrics used to value businesses, especially during sales. These terms help potential buyers understand a business’s financial health by looking at cash flow, but they serve different needs:

• SDE (Seller’s Discretionary Earnings) is preferred for smaller, owner-operated businesses where the owner’s personal compensation and perks are significant.
• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is more appropriate for mid-sized and larger companies where the owner is not directly involved in daily management.

By knowing these terms, owners and buyers can evaluate a business based on its cash flow in a way that matches their operational style.

Why Use SDE for Small Businesses?

SDE, or Seller’s Discretionary Earnings, is tailored for small businesses where the owner actively manages day-to-day operations. This metric factors in the owner’s personal financial benefits, which can significantly affect cash flow.

Why SDE Matters to Small Business Valuation

In small businesses, distinguishing between profits and owner compensation is often challenging. Here’s why:

1. Owner Compensation: Small business owners may not take a set salary. Instead, they may take an owner’s draw or combine personal perks with business expenses.
2. Blended Earnings: Since owner expenses often merge with business costs, SDE reflects the total earnings an owner can expect to receive, giving a more accurate valuation for potential buyers.

Example: An owner may take a $75,000 annual salary, though the industry average for similar roles is $150,000. SDE would adjust this discrepancy, presenting a realistic earning for the new owner.

Calculating SDE: Step-by-Step

Calculating SDE involves adjusting the business’s net income by adding back specific expenses and owner benefits. Here’s a breakdown:

SDE Calculation Steps:

1. Start with Net Income: Begin with the business’s reported net income.
2. Add Interest, Taxes, Depreciation, and Amortization: These reflect non-operational costs.
3. Include Non-recurring and Non-operating Expenses: Adjust for one-time or unrelated expenses.
4. Add Back Owner’s Compensation: Ensure that the full owner benefit is considered.

This comprehensive calculation gives potential buyers a clear view of total available earnings for owner-operated businesses.

When to Use EBITDA?

EBITDA is most commonly used for valuing mid-sized businesses, typically those with earnings over $1 million. In these cases, buyers assume they’ll need to hire someone to manage the company, making it essential to exclude owner-specific compensation from cash flow.

Key Reasons for Using EBITDA:

1. Objective Comparison: By removing personal expenses and owner’s compensation, EBITDA allows comparisons across companies of similar size.
2. Buyers’ Perspective: Larger business buyers, like private equity firms, focus on EBITDA since it represents what’s available after hiring professional management.

Example: A private equity buyer valuing a mid-sized company might look at EBITDA, assuming they’ll allocate funds to hire a manager, and base valuations on available earnings excluding owner compensation.

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Step-by-Step Guide to Calculating EBITDA

To calculate EBITDA, use the following adjustments but exclude the owner’s compensation:

EBITDA Calculation Steps:

1. Start with Net Income: Begin with the business’s net income, excluding personal owner expenses.
2. Add Interest, Taxes, Depreciation, and Amortization: This step ensures these indirect costs are factored back.
3. Exclude Owner’s Compensation: Ensure the final figure reflects an independently managed business scenario.

This straightforward approach makes EBITDA useful for mid-sized companies and institutional buyers.

SDE vs. EBITDA: Understanding the Buyer’s Perspective

When it comes to buyer preferences, SDE and EBITDA cater to different buyer profiles. Here’s how:

Why EBITDA Multiples Are Higher

EBITDA multiples tend to be higher than SDE multiples because companies that are not owner-dependent are often valued higher by investors. This higher valuation reflects the lower level of direct owner involvement, making the business more attractive for those seeking passive investments.

Impact on Business Value

For a company that could be evaluated with either metric, it’s worth noting that EBITDA-based valuations often attract higher-value buyers due to the passive investment potential.

When SDE and EBITDA Produce Similar Values

In certain cases, both methods can yield similar valuations. This often happens when adjusted EBITDA mirrors SDE after adjusting for the owner’s salary and perks.

In this example, both methods lead to an identical business value, meaning the chosen metric won’t significantly affect the final selling price.

Key Differences in Application

SDE is ideal for smaller businesses where the owner plays a significant role, while EBITDA is preferred for businesses with managerial staff or larger revenue levels. Choosing the right metric ensures that your business attracts the right type of buyer and is valued accurately.

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Practical Tips for Choosing SDE or EBITDA

1. Owner-Operated Business? Use SDE for businesses where the owner is actively involved.
2. Seeking Institutional Buyers? Go with EBITDA, especially if you anticipate corporate buyers or passive investors.
3. Mixed Use? When in doubt, calculate both and see which metric best represents the business’s operational reality.

When Should You Consider Adjusted EBITDA?

Adjusted EBITDA takes EBITDA a step further by including additional adjustments like non-recurring income and owner perks. It’s useful for businesses with fluctuating earnings, allowing for a more normalized valuation approach.

Example Scenario of SDE vs. EBITDA in Valuation

Let’s look at a scenario where SDE and EBITDA calculations differ. Suppose a business has an SDE of $1,000,000 and adjusted EBITDA of $750,000. After applying relevant multiples, both values end up similar, though they reflect different aspects of cash flow.

Common Questions

What’s the Main Difference Between SDE and EBITDA?

The main difference is that SDE includes the owner’s compensation and perks, making it ideal for small, owner-operated businesses. In contrast, EBITDA excludes these adjustments for a clearer comparison among larger companies.

When Should I Use SDE Over EBITDA?

Use SDE for small businesses where the owner is actively involved and the business is closely tied to personal expenses. Larger, manager-led companies should rely on EBITDA for better buyer transparency.

How Do I Know Which Multiple to Apply?

Multiples depend on buyer type. Institutional buyers and private equity firms often use EBITDA, while individual buyers or small business brokers may consider SDE.

For additional insights, check out CasinosBroker or visit the FAQ section on business sales.