SDE or EBITDA to Value a Business?

Distinguishing between SDE (Seller’s Discretionary Earnings) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is crucial when assessing your business’s worth. So, which metric should you prioritize for valuing your enterprise?

SDE and EBITDA stand as distinct approaches for gauging a business’s profitability or cash flow. The pivotal contrast can be summarized as follows:

• SDE serves as the principal metric for appraising small businesses, encompassing the owner’s compensation as an adjustment factor.
• EBITDA assumes the lead in assessing medium to large-scale businesses, omitting the owner’s salary from its adjustments.

Numerous adjustments factor into both SDE and EBITDA calculations. Elements such as interest, taxes, depreciation, and amortization are reconciled in both metrics, often featuring parallels in the adjustment process. Nevertheless, the crux lies in EBITDA’s exclusion of the owner’s compensation.

The aim of computing SDE and EBITDA is to ensure equitable comparisons among diverse businesses. To attain a standardized evaluation, consistency in applying the adjustment criteria for SDE and EBITDA is vital.

SDE comes into play when valuing small businesses wherein the owner is actively involved. In such cases, discerning the boundary between business profits and owner’s remuneration proves intricate. SDE effectively resolves this challenge by amalgamating business profits and owner’s compensation into a singular metric known as “seller’s discretionary earnings” – SDE.

For mid-sized businesses (exceeding $1 million in EBITDA) that can be managed by an external executive, EBITDA takes the center stage. While a small business proprietor might retain their compensation, a mid-sized business’s new owner would need to allocate salary resources for a manager’s role. EBITDA’s significance arises in valuing mid-sized businesses as they are often acquired by corporations necessitating the hiring and compensation of a manager or CEO post-acquisition.

Let’s delve deeper into the nuances of SDE and EBITDA, alongside some minor distinctions. Rest assured, with this insight, you’re better equipped to decipher your business’s true value.

When to Use SDE

SDE, as outlined by the International Business Brokers Association (IBBA), encompasses a business’s earnings prior to:

• Interest expenses or income (the “I” in EBITDA)
• Taxes (income taxes, the “T” in EBITDA)
• Depreciation and amortization (the “D” and “A” in EBITDA)
• Non-recurring income and expenses
• Non-operating income and expenses
• Owner’s complete compensation for a single owner, adjusting other owners’ compensation to market value.

SDE serves as the beacon guiding the valuation of small owner-operated businesses where the owner’s active involvement is intrinsic. In this realm, distinguishing between the business’s profits and the owner’s compensation proves challenging. Often, business owners forego a traditional salary, instead opting for a “draw.” Alternatively, an owner might compensate themselves below the benchmark they would allocate to an external manager. Consider a scenario where a business owner pays themselves a $40,000 annual salary while the market demand suggests $100,000 per year for their role.

Furthermore, myriad personal expenses or “perks” are frequently deducted by business owners through the business, expenses unlikely to be incurred by an external manager overseeing operations. These perks may encompass a personal vehicle, health club membership, vacation home expenses, and personal travel costs, among others.

SDE intervenes to harmonize these intricacies by amalgamating business profits and owner’s compensation into an all-encompassing entity termed “seller’s discretionary earnings” — SDE. This represents the cumulative compensation a prospective owner-operator could potentially realize. In essence, it encapsulates the potential earnings available, regardless of the form – whether it be perks, salary, draw, or dividends.

SDE is the indispensable metric for valuing small owner-operated businesses, given the intertwined nature of business profits and owner’s compensation. The typical demarcation between “business” and “personal” becomes blurred for most small business owners, rendering differentiation infeasible. Calculating an appropriate managerial salary for small businesses is notably more nuanced compared to their mid-sized counterparts.

Primarily tailored for businesses generating less than approximately $1 million in SDE, this calculation predominantly resonates with business brokers. These brokers specialize in businesses helmed by owner-operators, where SDE’s prowess truly shines.

When to Use EBITDA

EBITDA stands as a fundamental yardstick in business assessment, representing earnings (E) before (B):

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

The realm of EBITDA pertains to mid-sized businesses, those boasting EBITDA exceeding $1 million, and equipped for external management. In instances where owner-operators steer the ship, their compensation is rectified to align with prevailing market standards. For instance, if an owner presently earns $500,000 annually, yet the market rate totals $200,000, the compensation aligns with the latter.

If an owner doesn’t draw a salary, an appropriate market-level salary is subtracted from EBITDA computation. Likewise, if an owner or manager receives inadequate compensation, a market-aligned manager or CEO salary is deducted, culminating in EBITDA. Irrespective of the current owner’s compensation, normalization to contemporary market standards ensues, averaging between $150,000 and $300,000 for most businesses in the lower middle market.

In the event of an acquisition by a private equity group or company, the owner’s compensation remains unadjusted due to the necessity of hiring a manager. This contrasts with small businesses where owner compensation remains intact. In mid-sized ventures, a managerial salary is essential, mandating the owner’s compensation exclusion.

For instance, should a business exhibit an SDE of $1,000,000, and a competitor acquires it, paying a manager $200,000 annually, the resulting EBITDA becomes $800,000 ($1,000,000 – $200,000 = $800,000). EBITDA emerges as the rational choice for mid-sized business valuation since these businesses are commonly acquired by entities necessitating manager or CEO engagement post-transaction.

EBITDA’s typical application encompasses businesses generating over $1 million in EBITDA. Primarily employed by M&A advisors and investment bankers focused on business sales to private equity groups, competitors, and corporations, EBITDA also assumes significance in the realm of public companies, albeit net income often steals the spotlight.

EBITDA vs. Adjusted EBITDA: EBITDA is frequently intertwined with “adjusted EBITDA,” a term embodying additional alterations absent in standard EBITDA calculations, akin to SDE adjustments. Thus, when traversing the EBITDA landscape, it’s prudent to specify whether referring to EBITDA or adjusted EBITDA. Often, M&A advisors allude to adjusted EBITDA in their discourse on EBITDA.

Adjusted EBITDA encompasses modifications that elude standard EBITDA, including:

• Non-operating income or expenses
• Non-recurring income or expenses
• Unrealized gains or losses
• Owner perks

SDE or EBITDA

Presented below is a chart outlining the distinctions among SDE, EBITDA, and adjusted EBITDA:

Provided below is an illustrative example that elucidates the variances:

Are Multiples the Same for SDE and EBITDA?

In the aforementioned scenario, it might appear logical to consistently opt for valuing the business using SDE, as it could potentially yield the highest value. However, this assumption falls short of accuracy. Multiples associated with EBITDA naturally outstrip those of SDE due to the intrinsic notion that a business operated by a manager merits a higher valuation compared to one overseen by a fully engaged owner.

In scenarios where either SDE or EBITDA could viably value the business, the choice generally exerts minimal influence on the value. To illustrate this, consider the following example within the same business context, with both SDE and EBITDA valuation:

• $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

Assuming an owner’s compensation of $250,000 annually, the outcome yielded an SDE of $1,000,000 and EBITDA of $750,000 ($1,000,000 – $250,000 = $750,000). Remarkably, both valuation methods produced identical outcomes in this illustration.

Yet, what transpires when SDE’s valuation surpasses EBITDA-based valuation? While instinct might suggest favoring the SDE-based approach, businesses sold on EBITDA multiples often encompass working capital (comprising cash, inventory, accounts receivable, and accounts payable) within the purchase price. To underscore this point, let’s delve into one final scenario, casting light on the distinct outcomes arising from applying the multiple to EBITDA as opposed to SDE.

Clearly, real-world calculations might not align as precisely. Nevertheless, this example underscores that the value tends to remain comparable whether employing SDE or EBITDA.

Conclusion

Remember that the divergence in cash flow assessment, centered around owner’s compensation, forms the core contrast between SDE and EBITDA. For businesses generating under $1 million in earnings, opt for SDE, encompassing owner’s compensation. For those surpassing $1 million, opt for EBITDA, excluding owner’s compensation. In both scenarios, ensure utmost clarity in presenting the business’s value.