Valuing the Business – SDE vs EBITDA
The value of the small business is mostly determined by the cash flow (business brokers use the term “Seller’s Discretionary Earnings” instead to be more accurate). In this article we will explain what that is, along with the differences in SDE vs EBITDA.
Seller’s Discretionary Earnings (SDE) is defined as net income before taxes (operating income); interest; depreciation and amortization; owner’s compensation; owner’s benefit; and non-recurring expenses. Most small businesses sell for 1.5 – 3.5 (multiples) times the yearly SDE, depending upon the value factors of the business. Things that determine the multiple or value factors are the stability of historical earnings; business & industry growth; type of business (service with few assets to manufacturing with significant assets); location & facilities; stability & skill of employees; competition; diversification of products, service & geographical markets; desirability of the business; depth of management; and terms of the sale.
The national average is 2.76 times SDE. The inventory, equipment or fixtures are included in the price because they are what is required to generate the SDE. Some businesses need inventory, some need equipment (assets) and some need both, depending on the type of business. The amount of assets is one of the criteria that helps determine the value a business. Some value (but not many small business brokers) the business by its EBITDA, or Earnings before Interest, Taxes, Depreciation and Amortization. The multiple that is used is generally in the area of 4 to 6 times EBITDA. EBITDA is mostly used by investment bankers or M&A folks, people who usually handle bigger transactions ($ 20 million+ price tag). Business brokers count owner’s compensation and owner’s benefits as part of earnings or SDE (Seller’s Discretionary Earnings). You can also define SDE as EBITDA plus owner’s salary plus owner’s benefits. Basically, if you take SDE times 1.5 to 3.5 multiple, you should have similar numbers if you calculate EBITDA times 4 to 6 times. The reason business brokers don’t usually go by EBITDA times 4 to 6 times is that, it’s basically the owner’s discretion to pay him/herself salary of whatever the amount and most owners write off a lot of personal expenses through the business (called owner’s benefit).
The list of documents used to prepare a valuation and in order to package the business for sale; 1) last three years of profit & loss statements including balance sheet 2) last three years of tax returns 3) copy of the lease 4) major fixture, furniture & equipment list.
Of course, there needs to be a discussion with an Owner to determine the owner’s benefits to come up with the final number.
Understanding SDE vs EDITDA
Smaller companies (around $500K to a $1 million or less in earnings) are valued based on SDE, and almost every business-for-sale website uses SDE in their listings. However, larger companies (generally above $1 million in earnings) use EBITDA. If your earnings are in the $500K to $1.5 million mark, it is important to know the difference between SDE and EBITDA.
I remember having a conversation with a upset business owner over our opinion on the value of his business. He said that was far too low, because he heard that 4 to 5 times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is normal, and he felt he was above normal. He said at his earnings of $450,000 he should be close to $3 million in value.
Since his earnings were below $500,000, we used seller’s discretionary earnings (SDE, also known as DE), and the multiples on SDE are lower than multiples on EBITDA. In other words, the $450,000 SDE number should be multiplied by 3 or 4, not 5 or 6.
So I used EBITDA to calculate the same business value and the multiple of EBITDA was about 6.5. So he actually was “above normal” in our opinion, but of course the real problem was that the valuation was at least $1 million below what he expected.
Similarities of SDE AND EBITDA
Both SDE and EBITDA attempt to standardize the earnings number by excluding items that are variable and discretionary from company to company. For example, one company may have a heavy debt load while another may have none. So we exclude interest expense from the both DE and EBITDA. A buyer then calculates what his debt load will be, if any, and can adjust the earnings number to fit his situation. Same with taxes – some companies have different tax strategies, so we use a pretax earnings number. Depreciation and Amortization is a non-cash expense, and also are more of an accounting method rather than real-world depreciation of assets, so we exclude that as well.
Note: But don’t completely discount depreciation of assets! A smart seller will capitalize and depreciate assets (vs. expensing them) in the years before a sale in order to boost earnings. A smart buyer will remove depreciation, but then look at expected capital expenditures (“CapEx”) so they know they will have the cash flow in the future to buy needed assets.
SDE (or DE)
Seller’s Discretionary Earnings (also called Discretionary Earnings) is used for smaller companies (generally under $500K in earnings) that are typically owned by the manager. In this case it can be tough to separate out what the owner/operator gets vs. the earnings of the company. So we add them together into one number. Another way of saying that is to “addback” one owner’s salary (in addition to the interest, depreciation, etc. mentioned above). Thus when
you as a buyer are looking at a business that has an SDE of, say, $200,000, you know that you have $200K to spend on living, taxes, interest and capital expenditures. For example, if you historically have been living on a $120K salary, then you can think of the business as making $80K above that, and that $80K is available to service debt, enhance your savings account, etc.
EBITDA
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is generally used to show an investor/buyer (vs. an owner/operator) how much a company is earning. The investor does not actively run the company, and must pay a professional manager to do that for him. Thus the manager’s salary is included in the earnings calculation. It is not added back as in the SDE calculation. Simply put, EBITDA is a way for an investor to measure the return on investment he will receive should he purchase a company.
I should mention that advanced investors go further than EBITDA and use discounted free cash flow or discounted cash flow (DCF) analysis. EBITDA is not a true cash flow, and really what an investor wants to know is how much cash a business will generate in the future. A DCF model includes taxes, working capital, growth, CapEx and anything that impacts cash flow, and then discounts those future cash flows to a present value. DCF is pretty hard to do correctly, so it usually is only used for larger deals well above a few million in value.
Other Differences in SDE vs EBITDA
Sometimes small businesses (typically those sold using seller’s discretionary earnings, SDE, as the valuation metric) are sold with absolutely nothing in the business, no gas in the car at all. No cash, no payables, and no accounts receivables. The new owner needs to recognize that and leave themselves enough cash to be able to fund the working capital needs of the business.
Larger companies (typically those that use EBITDA as the valuation metric), are sold with gas in the car. That is, a new owner buys the company with the expectation that enough working capital (including cash, AR, AP, inventory, etc.) is left in the company to continue to run it.
That doesn’t mean that all cash is always left in the business. Excess cash, which would be the amount of extra cash on hand that isn’t required to run the business, is taken out and “taken home” with the seller.
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