Valuation

SDE vs. EBITDA: Which One Prices Your Business?

Most small businesses get priced on SDE, while larger companies with a manager already in place get priced on EBITDA. Which one applies to yours comes down to who runs the business day to day.

The short version

SDE and EBITDA are two ways of stating what a business earns, and neither one is the profit printed on the tax return. Each adjusts that profit with a different buyer in mind.

SDE fits a business the owner runs in person, and EBITDA fits one a hired manager runs. Which measure gets used follows how the business operates today, not which number looks better.

Where owners get tripped up is mixing the two. A price quoted on one basis tells you nothing until you know which basis produced it.

What SDE counts

SDE stands for seller's discretionary earnings. It starts with the profit on the tax return and adds back the pay and perks the business gives the owner, on the theory that a buyer working in the business keeps all of it.

The usual add-backs are:

• The owner's salary
• Personal costs the company covers for the owner
• One-time costs that will not repeat

The reasoning is simple enough. A buyer who steps into the owner's job steps into that entire stream of cash, and the salary the seller was taking becomes money the buyer can draw or put back into the business.

That is why most small owner-run companies sell on SDE. Staffing firms at this size usually do, and so do service companies and consulting practices.

What EBITDA counts

EBITDA stands for earnings before interest, taxes, depreciation and amortization. The figure is always stated before those four costs come out:

• Interest
• Taxes
• Depreciation
• Amortization

One more rule sets EBITDA apart from SDE: the business gets charged for management before the number is stated, so a paid manager's salary counts as a cost of running the company.

The owner's pay does not come back out. What is left is what the business earns on its own, and that figure holds up no matter who owns the company.

That is why buyers reach for EBITDA on larger companies: it lets them compare two businesses side by side without untangling how each owner chose to pay himself.

The same business, both ways

Here is one set of books run through both measures, using round numbers so the gap between the two totals is easy to see.

Nothing about the business changed between the two totals; only the question did. SDE asks what a working owner takes out of the business each year.

EBITDA asks what remains after paying someone to run it. Neither number is padded; they answer two different questions.

Why the multiple changes with the basis

A price is earnings times a multiple, and a multiple only means something next to the basis it was built on.

SDE is the bigger number, so its multiple is the smaller one. EBITDA is the smaller number, so its multiple is the bigger one.

As a rough guide, small companies often sell at two to four times SDE. EBITDA multiples at this size run higher because the base number is lower, and those ranges are background only, not a quote on any particular business.

The expensive mistake is crossing the two systems: price an SDE figure at an EBITDA multiple and you overstate the value by a wide margin. When someone quotes you a price, the first question is which basis it sits on.

Add-backs buyers accept and reject

Every add-back gets tested when a buyer goes through the books. Buyers accept the ones you can document, and they reject anything that is really just a normal cost of staying in business.

Buyers usually accept

• Owner salary above what a manager would cost
• A personal vehicle the business pays for
• A one-time legal bill
• Personal insurance the company carries for the owner

Buyers usually reject

• Normal wages for the crew
• Rent on the space the business uses
• Ongoing marketing spend
• Any cost the buyer will still pay after closing

A rejected add-back costs more than the dollars. It makes a buyer suspicious of every line that follows, so keep the list short and keep documentation for each item.

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