SDE vs EBITDA: Which Financial Metric is Right for Your Business?

Tracking your company’s financial performance is standard operating procedure for any business owner. It’s even more important when you want to value your business for sale.

Potential buyers want to compare your business performance to similar companies in your industry, but accounting methods differ. The one you choose should provide for a fair comparison and show your business in its best light.

The two most commonly used financial metrics for measuring the profit or cash flow of small businesses and middle market companies are seller’s discretionary earnings (SDE) and earnings before interest, taxes, depreciation, and amortization (EBITDA).

Which is best for your business depends on its size, some of its characteristics, and the type of buyer you hope to attract.

What Is Seller’s Discretionary Earnings (SDE)?

SDE is an accounting method that measures a company’s profits by adding back certain discretionary expenses to the bottom line.

Expenses commonly added back when calculating SDE include:

• non-recurring expenses like a website redesign
• non-operating expenses such as a lawsuit settlement
• interest paid on outstanding loans
• taxes paid
• depreciation and amortization
• the owner’s compensation
• the owner’s personal expenses

Adding back the items listed above, also called recasting your financials, gives potential buyers a clear picture of how much money they’ll be able to pocket from the business, and it can increase your business valuation so you achieve a higher sale price.

When to Use SDE Accounting and Why

SDE is most often used by smaller businesses under $1 million in earnings that are run by an owner-operator.

The idea behind the SDE calculation is that not all business owners will choose to spend their money in the same way. An owner’s compensation, debts, perks, and other types of expenses not necessary for operating the business will vary widely depending on the choices they make.

For example, a current owner who includes perks like summer vacations, auto leases, and health club memberships in their salary might pay themselves $200,000. A new owner might not want to take vacations or join a health club, reducing their compensation to $100,000. By recasting financials using SDE, these discretionary expenses won’t cloud the actual operating profit the company generates.

It’s not just that the discretionary expenses you include in your accounting might not apply to a new owner. By including these types of expenses you’ll reduce your company’s net income and the value of your business as you’ll see below.

How SDE Works

Here’s an example of what happens when a small business with revenues of $500,000 uses a straight-up net income calculation versus the seller’s discretionary earnings accounting method.

How SDE Affects Business Valuation

After deducting necessary and discretionary expenses of $185,000, the net income of the company appears to be $265,000. But when interest, travel, charitable contributions, and the owner’s salary are added back, the net profit of the business is $375,000, an increase of $110,000 that a new buyer can use in any way they want.

In addition to providing a clearer view of the business’s profits, SDE accounting might also result in a higher valuation for the business.

Valuations are calculated using a so-called multiple such as 2 times earnings. At a multiple of 2 times earnings, the value of the business using the net income calculation is $530,000. But when SDE is used, the business valuation increases to $750,000.

What Is EBITDA?

Like SDE, EBITDA is a metric that measures the net profit of a company by excluding items that are likely to differ from one company to the next. Using EBITDA, earnings before interest, taxes, depreciation, and amortization, allows business owners and prospective buyers to compare apples to apples.

For example, the cost basis for business equipment changes when the business is acquired by a new owner, and therefore, the depreciation credit will also change. So will amortization credits on intangible assets. Likewise, a new owner might not carry a loan or the loan amount will change, and the interest expense will change as a result.

The EBITDA calculation normalizes a company’s expenses so that a buyer can make a fair comparison between companies.

EBITDA is often calculated using other adjustments besides interest, taxes, depreciation, and amortization.

Adjusted EBITDA, as it’s called, excludes these types of items:

• non-operating income or expenses
• non-recurring income or expenses
• unrealized gains or losses such as an increase in the value of stocks a business holds

EBITDA calculations also typically adjust the manager’s salary up or down so that it aligns with market values for the industry.

Suppose you own and operate a business and pay yourself $200,000, but you could hire a manager at a market rate of $100,000. Using an EBITDA calculation, you would include $100,000 of salary in your business expenses but add back $100,000 to account for the excess salary you are paying yourself.

When to Use EBITDA Accounting and Why

EBITDA is typically used by middle-market and larger businesses with income in excess of $1 million that are typically run by a professional manager, rather than the business owner.

Private equity groups and strategic buyers will usually insist on financials that use EBITDA rather than SDE because these types of companies almost always hire professional managers to run their companies.

How EBITDA Affects Business Value

In general, EBITDA multiples are higher than the multiples applied to SDE accounting methods because businesses run by professional managers are regarded as more valuable than those run by the owner.

The higher multiple used for EBITDA calculations often result in a higher valuation, although the valuations vary depending on the size of the company, industry, and type of buyer you're looking to attract. 

Choosing Between EBITDA and SDE Accounting Methods

A business’s earnings will usually always be higher when SDE is used because the owner’s compensation is added back in this calculation. However, the multiples applied to value a business are typically higher for EBITDA valuations than SDE valuations. That means a company that uses EBITDA to calculate profits can achieve a higher valuation than one that uses SDE, even if it has less income.

Let’s look at what happens to the valuation of two similar companies with the same earnings when one uses EBITDA and one uses SDE.

• Company A has income of $500,000
• Interest expense is $50,000
• Depreciation expense is $100,000
• The owner of the company takes a salary of $250,000

Because company A uses EBITDA to calculate earnings, the owner’s salary can’t be added back in full. But the market rate for a manager’s salary in company A’s industry is $100,000, so $150,000 (the difference between the owner’s salary and the market rate salary) can be added back to the bottom line using EBITDA.

EBITDA for company A is $500,000 + $50,000 +$100,000 + 150,000 equaling $800,000. At a multiple of 3 times earnings, the value of company A is $2,400,000.

Company B has the same income, interest expense, and depreciation expense as company A, but because company B uses SDE, the full amount of the owner’s compensation–$250,000–can be added back.

SDE for company B is $500,000 + $50,000 + $100,000 + $250,000, equaling $900,000. At a multiple of two times earnings, the value of company B is $1,800,000.

Of course, your company’s size, industry, and the type of buyer you’re likely to attract also determine the calculation you use. It will also determine whether you should work with a business broker or M&A advisor. Small businesses like Main Street businesses usually work with business brokers. They attract buyers who plan to run the company, and both the broker and buyer will likely want to see your financials cast using SDE. Middle-market and larger businesses are usually sold through M&A advisors. These advisors and the typical buyers for these companies usually want to see financials cast using EBITDA.

For more information about business valuations, see our article, How To Value a Business for Sale.

The BizQuest Valuation Calculator can help you find an estimate for the value of your business by returning a valuation range based on your business earnings and the average market valuation multiples of businesses in your industry.