How is business value measured?
Many business owners believe that the most effective way to build value is to: grow sales, cut costs and make acquisitions. Instead of chasing revenue, a shift to driving the multiple upward through value acceleration could lead to exponential increases in business value. (VALUE = PROFIT X MULTIPLE)
Understanding SDE vs. EBITDA is essential for business owners who want to accurately assess their company’s value before a sale or transition. Seller’s Discretionary Earnings (SDE) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) are both profitability metrics used in business valuation, but they are applied in different contexts and serve different buyer audiences.
SDE is typically used for smaller businesses and includes the owner’s compensation and personal benefits, making it most relevant for owner-operated companies. EBITDA is more commonly used for middle-market businesses and focuses on operational earnings that would be available to a new owner or investor after removing discretionary items.
Windes helps business owners understand which metric applies to their situation, how buyers and valuation professionals will use it, and how improving the underlying earnings can increase business value and exit readiness.
Is similar to SDE and is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. Although the concept is similar to SDE, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) calculations are typically used for larger businesses with more disciplined financial reporting. One of the big differences between the two is that, in EBITDA calculations, the manager’s salary is not added back, whereas, in SDE calculations, the manager’s salary is added back with the assumption that the buyer is going to replace the seller as the owner/operator of the business. Private Equity Groups often use EBITDA calculations as a starting point in their initial cash flow assessments. They may also use EBIT (Earnings Before Interest and Taxes) as a metric. To complicate the process, we sometimes use an Adjusted EBITDA calculation as a hybrid method when the financials are fairly disciplined and the buyer is probably a financial buyer, such as a Private Equity Group, but the seller is taking a salary substantially higher than the salary of a non-owner manager.
Seller’s Discretionary Earnings (SDE) is a metric for determining the historical cash flow of a business. It is a recasting process that starts with the net profit of a business, from either the business tax return or the year-end income statement. (We prefer to use the net profit from the tax return, as the tax return has typically been vetted by an accountant and most financing for a business that uses SDE as a metric is SBA guaranteed, which relies heavily on tax return calculations.) The owner’s salary, owner’s benefits, non-cash expenses, such as depreciation and amortization, and non-recurring expenses such as a move or litigation, are added back to the net profit to calculate the SDE. The SDE is usually used in smaller businesses, because many times the owners of those types of businesses aggressively expense a lot of personal benefits, such as use of automobiles and entertainment.
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Frequently Asked Questions
SDE, or Seller’s Discretionary Earnings, represents the total financial benefit you personally get from your business, not just your salary, but also benefits, perks, and discretionary expenses the business covers on your behalf. It’s the metric most commonly used to value smaller, owner-operated businesses because it captures what a new owner-operator could actually expect to take home after replacing you in the day-to-day.
EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, measures how profitable your business is at the operational level, independent of how it’s financed or your personal compensation. It’s the metric institutional buyers, private equity firms, and other financial acquirers typically use, because it reflects earnings a new owner could expect regardless of who’s running the business day to day.
If you’re an owner-operator running a business generating roughly under two to three million in revenue and you’re likely to sell to an individual buyer, SDE is probably the more relevant number for you. If your business is larger, has a management team beyond you, and could realistically attract private equity or other institutional buyers, EBITDA is the metric they’ll use to evaluate it. Many owners aren’t sure which category they fall into, which is exactly the kind of question worth raising with your advisor well before you’re ready to go to market.
