SDE vs EBITDA — how small businesses are really valued

When you look at a business for sale, the asking price is usually a multiple of some measure of profit. The trouble is that there are two common measures, they give very different numbers, and sellers do not always say which one they are using. Understanding seller's discretionary earnings (SDE) and EBITDA is one of the first skills a buyer needs.

Why net profit is not enough

The net profit on a small business's tax return is rarely a good guide to what a new owner will earn. Owners legitimately run their businesses to suit their own tax position and lifestyle. They may pay themselves a below-market or above-market salary, put family members on the payroll, run a car through the business, or claim one-off costs in a particular year. Depreciation and interest also depend on choices that a buyer will not inherit.

So buyers and sellers adjust, or normalise, the profit to show what the business really earns. SDE and EBITDA are two ways of doing that.

What EBITDA means

EBITDA stands for earnings before interest, tax, depreciation and amortisation. It aims to show the operating profit of the business independent of how it is financed and how its assets are accounted for.

Crucially, EBITDA treats the owner's role as a cost. If the business needs a general manager, EBITDA assumes one is paid a market salary, whether that person is the owner or an employee. What is left is the profit available to the owners of the business as investors.

EBITDA is the usual measure for larger businesses that can run with a management team, and for buyers such as private equity firms or companies who will not work in the business themselves.

What SDE means

Seller's discretionary earnings starts from a similar place but goes a step further. It adds back the owner's own salary and benefits, showing the total financial benefit available to one full-time owner-operator before they pay themselves.

SDE is the common measure for smaller owner-operated businesses, where the buyer will step into the owner's role. It answers the question: if I buy this business and run it myself, how much money does it produce for me, before I repay any acquisition debt?

The difference in one line

EBITDA is the profit after paying someone to run the business. SDE is the profit before paying the owner who runs it.

A worked example

Here is an illustrative business. The figures are examples only.

• Net profit before tax on the financial statements: $180,000
• Interest on an existing business loan: $15,000
• Depreciation: $25,000
• Owner's salary and superannuation: $90,000
• Personal share of the owner's car and phone costs run through the business: $12,000
• One-off legal costs from a dispute now resolved: $8,000
• Owner's spouse on payroll who does little work: $30,000

To get to SDE, add back all of these to the net profit: $180,000 + $15,000 + $25,000 + $90,000 + $12,000 + $8,000 + $30,000 = $360,000.

To get to EBITDA, start from SDE and deduct a market salary for the role the owner performs. If a general manager would cost $130,000 including super, EBITDA is $360,000 − $130,000 = $230,000.

Now apply multiples, again purely as illustrations. At 2.5 times SDE, the business would be priced at $900,000. At 4 times EBITDA, it would be priced at $920,000. Those happen to land close together, which is the point: the multiple applied to SDE is usually lower than the multiple applied to EBITDA, because SDE is the larger number. Multiples vary widely by industry, size, growth and risk, so treat these as arithmetic, not market guidance.

The danger comes when the measures are mixed up. Apply an EBITDA-style multiple to SDE and the price is overstated. In the example, 4 times SDE would be $1.44 million, well above what the earnings support.

Scrutinise every add-back

Add-backs are where most of the negotiation happens. A seller's broker will present the most favourable reasonable view. Your job is to test each one.

Ask:

1. Is it genuinely discretionary or one-off? Legal costs from a single resolved dispute may be. Repairs that happen every year are not.
2. Is there evidence? Ask for invoices, payroll records and bank statements.
3. Will the cost really disappear? If the spouse on payroll actually does the bookkeeping, you will need to pay someone else to do it.
4. Is the owner's salary realistic? If the owner works 70 hours a week across three roles, replacing them may cost more than one salary.
5. Are there costs missing? Owners sometimes under-spend on maintenance, marketing or staff before a sale. A buyer will have to restore that spending.

Other adjustments that matter

Normalising profit is not only about add-backs. Also consider:

• Rent. If the owner also owns the premises and charges below-market rent, profit is overstated for a buyer who will pay market rent.
• Capital expenditure. EBITDA and SDE ignore the cost of replacing equipment. A business that needs heavy ongoing investment converts less of its earnings into cash.
• Working capital. Stock and debtors tie up cash. A sale price is usually set on the assumption that a normal level of working capital comes with the business; agree this explicitly.
• Trends. Three years of figures tell you more than one. A rising or falling trend changes what the business is worth.

Which measure should you use?

Use SDE if you plan to work full time in the business and it is small enough that one owner-operator runs it. Use EBITDA if the business has, or needs, a management layer, or if you plan to step back.

Whichever you use, make sure you also check that the earnings can cover your living costs, debt repayments, tax and reinvestment. A price that looks fair on a multiple can still be unaffordable once debt is serviced.

A multiple only means something when you know what it is being multiplied by. Always ask whether a price is based on SDE or EBITDA, and rebuild the number yourself.

Valuation is broader than a multiple

Multiples are a shorthand. A proper valuation also weighs customer concentration, the quality of the team, the lease, competition, growth prospects and the risk that profit depends on the seller personally. These are tested in due diligence; see our financial due diligence checklist.

How we can help

Kainos Consultants rebuilds the earnings of businesses our clients are considering, tests each add-back against the records, and helps them form a view on price before they negotiate. Read about our business sales and purchases service, or contact us to discuss a business you are looking at.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.