If you’re a business owner preparing to sell, you’ve probably come across the acronyms EBITDA and SDE. You might be wondering what these terms mean and how they impact your business valuation.
In this post, I’ll dive into the main differences between these two metrics and explore their significance in the selling process.
Let’s get started.
What is the difference between EBITDA and SDE?
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and SDE (Seller’s Discretionary Earnings) are both financial metrics used to evaluate a business’s performance and assess its value.
You can think of EBITDA as commonly used by larger businesses, while SDE being more relevant for smaller, owner-operated businesses.
EBITDA is a measure of operating performance that eliminates the effects of financing, taxes, and non-cash expenses. By excluding these items, EBITDA allows investors and business owners to focus on a company’s core operations. Private equity groups typically use EBITDA for their initial cash flow assessments.
SDE, on the other hand, reflects the total financial benefit an owner can derive from a business. It includes the owner salary, personal benefits and perks, and non-recurring expenses, as well as non-cash items like depreciation and amortization.
Often times, smaller businesses aggressively expense personal benefits, so SDE can be a helpful way to assess their true market value.
Is SDE higher than EBITDA?
SDE and EBITDA are usually not directly comparable, as they serve different purposes and are used for different types of businesses.
As mentioned above, SDE is more relevant for small business valuation, while EBITDA is used for assessing the operating performance of companies of any size.
With that said, if you’re transitioning between the two metrics – SDE will be higher than your EBITDA (since it has your salary, perks, and one-time add backs included).
What is the difference between SDE and net income?
Net income, also known as net profit, is the bottom line of a company’s income statement. It represents the total revenue minus all expenses, including taxes, interest, and depreciation.
SDE is a more comprehensive metric that accounts for the owner’s compensation and other discretionary expenses. It’s a better indicator of the true financial benefit a business owner can extract from their company.
How is SDE calculated?
Calculating SDE involves a series of adjustments to the business’s net income:
- Add back the owner’s salary and benefits
- Add back any non-operating or non-recurring expenses
- Add back non-cash items like depreciation and amortization
- Adjust for any differences in business or industry norms
How do you calculate EBITDA from SDE?
To calculate EBITDA from SDE, you need to make some adjustments:
- Starting with SDE, subtract the owner’s salary and benefits: Since EBITDA doesn’t include the owner’s compensation, you need to remove this amount from the SDE.
- Subtract any non-recurring or discretionary expenses: EBITDA only considers normal operating expenses, so you’ll need to remove any non-recurring or discretionary expenses from the SDE.
- Add back interest, taxes, depreciation, and amortization: EBITDA adds back these expenses, so you need to include them in your calculation.
For reference, here’s the formula to make SDE to EBITDA calculations:
EBITDA = SDE – Owner Salary & Benefits – Non-recurring or Discretionary Expenses + Interest + Taxes + Depreciation + Amortization
SDE vs. EBITDA example
Let’s say you’re a small business owner looking to sell your company. Your business has a net income of $150,000, and you pay yourself a salary of $80,000.
In addition, you have $20,000 in non-operating expenses, and your business incurs $10,000 in depreciation and amortization.
To calculate the SDE, you would add back your owners salary, non-operating expenses, and non-cash items to the net income:
$150,000 (net income) + $80,000 (owner’s salary) + $20,000 (non-operating expenses) + $10,000 (depreciation and amortization)
= $260,000 (SDE)
At this point, let’s calculate EBITDA from the SDE figure:
$260,000 (SDE) – $80,000 (owner’s salary) – $20,000 (discretionary expenses)
= $160,000 (EBITDA)
As you can see – in this example, the SDE is $260,000, and the EBITDA is $160,000.
Both metrics provide valuable insights into your business’s financial performance and potential value to a buyer.
Frequently Asked Questions
Why is SDE more relevant for small businesses?
SDE is more relevant for small businesses because it takes into account the manager’s salary and other discretionary expenses.
This provides a clearer picture of the financial rewards a potential buyer can expect, as small businesses often rely heavily on the owner’s involvement in daily operations.
Can I use both SDE and EBITDA to value my business?
Yes, using both SDE and EBITDA can provide a more comprehensive understanding of your business’s financial performance.
From a valuation perspective, moving from an SDE owner operator to EBITDA will often result in a significant increase in what you’re business is worth. If you’re interested in more, I cover this in greater detail in my post about how to increase valuation multiples.
How do I determine which metric is best for my business?
The choice between SDE and EBITDA depends on the nature of your business and its size. If you’re a small business owner with significant involvement in daily operations, SDE is likely the more appropriate metric.
If your business is larger or more passive, EBITDA is likely a better choice.
How do lenders view SDE and EBITDA?
Lenders often use EBITDA as a key metric to assess a business’s ability to repay loans, as it provides an overview of the company’s operating performance.
SDE may be considered as well (depending on size), but it’s important to note that lenders may focus on the more widely used EBITDA.
How do SDE and EBITDA impact the multiple used in business valuations?
The multiple used in business valuations is typically based on the industry, business size, growth potential, and risk factors.
SDE and EBITDA play a crucial role in determining the multiple, as they provide insight into the business’s financial performance. A higher SDE or EBITDA may lead to a higher valuation multiple, resulting in a higher overall valuation for your business.
Can I improve my SDE or EBITDA before selling my business?
Yes, you can take steps to improve your SDE or EBITDA before selling your business. Some strategies to increase business value include:
- Cutting unnecessary expenses
- Increasing revenues
- Streamlining operations
- Improving profit margins
- More disciplined financial reporting
If you’re interested in boosting your valuation, you can check out my free Valuation Booster Blueprint on my site. It contains 58 strategies on how to do just this.
How does the choice between SDE and EBITDA affect negotiations with potential buyers?
The choice between SDE and EBITDA can influence negotiations by highlighting different aspects of your business’s financial performance.
Presenting a higher SDE might make your business more attractive to buyers interested in owner-operated businesses, while a strong EBITDA may appeal to buyers looking for a more passive investment.
Understanding the priorities of potential buyers can help you present the most relevant metric and secure the best possible deal.
How do SDE and EBITDA relate to cash flow?
Both SDE and EBITDA provide insights into a business’s cash flow, which is crucial for potential buyers.
SDE offers a comprehensive view of the owner’s cash flow, including salary and discretionary expenses. EBITDA, on the other hand, focuses on operating cash flow, excluding financing, taxes, and non-cash items.
While neither metric is a direct measure of cash flow, they can help buyers understand the cash-generating potential of a business.
Are SDE and EBITDA relevant when valuing a start-up or a business with negative earnings?
While SDE and EBITDA may not be as relevant for valuing start-ups or businesses with negative earnings, they can still provide some insight into a company’s financial performance.
In these sorts of cases, other factors like growth potential, market size, and intellectual property may be more important in determining a business’s value.
Either way, understanding the reasons behind negative earnings and working to improve financial performance can enhance your start-up’s attractiveness to potential buyers.
Conclusion
As we covered, SDE and EBITDA are two commonly used metrics to measure business performance and value.
Your choice depends on the nature of your business, its size, and what lenders or buyers prioritize. Improving SDE or EBITDA before selling can increase your company’s value and make it more attractive to potential buyers, and exit your business in a position of strength.
Whether you’re working with M&A advisors, business brokers, or going at it alone, grasping these concepts will make you better equipped to present your company’s financials in the most favorable light, and secure the best possible deal in your sale.
