SDE vs EBITDA: Which is Better for Determining the Value of a Business?

A guide to understanding these two metrics of financial performance to value a business.

SDE (Seller's Discretionary Earnings) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) are the two most commonly used numbers for valuing a business. When you start looking at business summaries, you will likely see one or the other as a measure of cash flow. Let's take a closer look at SDE vs EBITDA to better understand the differences and when each will be used in a business listing.

What is SDE?

SDE is a metrics of determining the cash flow of a business. This is mainly used when doing a valuation of a small business that is actively run by an owner-operator. Small business is usually defined as a business with $1 million or less in earnings. If you are looking for a business with an asking price of $500,000 or less, this will be the most commonly used metrics you will encounter. The main difference is the seller's discretionary cash flow will include the owner's compensation and benefits. If you plan to take over running the day-to-day operations of the business, SDE is a good estimate of your future earnings.

SDE as defined by the International Business Brokers Association (IBBA):

The earnings of a business prior to income taxes, depreciation, amortization, interest, non-operating income and expenses, nonrecurring income and expenses, one owner's entire compensation (including benefits and any non-business or personal expenses paid by the business).

What is EBITDA?

EBITDA is used in medium to large business valuations with operating profit above $1 million. These businesses are typically bought by other companies or private equity firms and need a manager or CEO to run the day-to-day operations. In this type of valuation, the owner's compensation is not considered an add-back because that salary will be needed to hire a manager to replace the active owner. In many cases, business of this size will already have existing management and a passive ownership structure.

Another form of EBITDA you may encounter is Adjusted EBITDA. This is used if the salary needed to replace the owner is less than the current compensation paid. For example, an owner pays himself $150,000 in compensation. If a manager can be hired at a salary of $100,000, the EBITDA can be adjusted to add-back the additional $50,000 above market value the owner is paying himself.

EBITDA as defined by the International Business Brokers Association (IBBA):

Earnings of a business prior to interest (expense or income), income taxes, depreciation and amortization expenses.

How is SDE calculated?

SDE = Net Income + Add-Backs

Add-backs are discretionary spending or one-time expenses that the new owner would not be responsible for after purchasing the business. An example of an add-back would be the owner using company funds to pay for personal vehicle maintenance. The vehicle will not transfer with the business, so that expense will not be incurred by the new owner.

SDE Example:

In the example above, the owner is the sales manager and pays himself an annual salary of $50,000. This number is used in the SDE calculation. Other benefits and perks are added back to get the total adjusted SDE. Note in the example, the owner's spouse is doing the bookkeeping for the business and not taking a salary. This is a service that will need to be replaced and paid for by the new owner, so that is adjusted to reflect the future added cost.

How is EBITDA calculated?

EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortization

As referenced earlier, Adjusted EBITDA will add-back any additional compensation above the market value of hiring a manager.

In the SDE example above, we can calculate the EBITDA value by taking the Adjusted SDE and subtracting owner's compensation of $50,000 and any benefits/perks that would be offered as part of a compensation package to a future manager.

Note: In most cases, EBITDA will be lower than SDE because it doesn't take into account the owner's compensation and benefits. For this reason, the multiple will be lower when determining the value of a business using SDE. For example, the average SDE for a business with earnings between $500k-$1Mil is 2-3x SDE. In a business with $1-$2Mil or more in earnings, the multiple is 3-6x EBITDA. Keep in mind many factors go into the multiple chosen for valuing a business including industry, diversity of customer base, and sales. I highly recommend getting a copy of the annual business reference guide that takes all factors into account when selecting an average multiple for each unique business.

Summary: SDE vs EBITDA

The main difference between SDE and EBITDA is owner's compensation and benefits. For non-private equity buyers looking to work actively in a business, SDE provides the best indicator of your expected profit. When evaluating a business, consider the metrics used to understand the cash flow of the business. If it is ever unclear, ask the business broker for a detailed outline of how SDE was calculated and the multiple used in the valuation. If they are unable to provide that information, it may be a signal to move on and continue your search.