Business valuation is an integral step when formulating an exit strategy, as it gives you leverage during negotiations and helps you maximize the expected financial gain.
But how should you calculate a business’s value to reflect its revenue generation capacity?
Most M&A experts recommend using the seller's discretionary earnings (SDE) and earnings before interest, taxes, depreciation, and amortization (EBITDA) to determine a business’s financial health.
In this guide, we’ll discuss how these metrics give you a clear picture of the expected financial gain upon selling or buying a business. We’ll compare SDE vs. EBITDA in-depth, including their pros and cons, similarities and differences, and how to calculate them.
SDE and EBITDA fall under market-based business valuation models.
Can’t read the whole article right now? Here’s a quick rundown of how SDE and EBITDA compare, including their pros, cons, and best use cases:
SDE
EBITDA
Measures a business’s cash flow to determine the owner-operator’s expected earnings.
Determines how much a company generates from its core operations to help interested buyers assess financial performance.
Pros
Pros
Cons
Cons
Best For
Best For
Small businesses where the owner has a central role in the day-to-day operations. It is typically used for businesses that generate less than one million in annual revenue.
Medium and large businesses with over one million annual revenues.
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Seller's Discretionary Earnings (SDE) is a metric used to determine the total available cash flow to an owner-operator of a small business. When conducting a company valuation, a small business is defined as an entity that generates less than one million dollars in annual revenue.
SDE calculates a small business's total revenue before deducting taxes, loan interests, depreciation, and amortization. This helps create a clear picture of the total cash flow prospective buyers should expect when they take over the business operations.
Calculating SDE involves adding back all the relevant expenses deducted from the generated revenue. You can start with the net profit or earnings before taxes (EBT), but we recommend the latter.
Use the formula below:
SDE = EBT + Owner’s Salary + Owner Benefits + Discretionary Expenses + Interest Repayments + Depreciation + Amortization
Scenario: A fintech company reports the following financials:
SDE Calculation:
SDE = 550,000 + 60,000 + 30,000 + 10,000 + 5,000 + 5,000 + 10,000
SDE = $670,000
It is a type of exit multiple used for small business valuation. It is calculated by multiplying a company’s SDE by a pre-determined industry metric (multiple). The industry-specific multiple varies based on market conditions, business size, and growth potential.
Scenario: Let’s keep the example of the fintech business with an SDE of $670,000. Also, let’s assume the industry-specific multiple for a fintech business with less than one million in annual revenue is 7.7X.
SDE Multiple = SDE X Industry-Specific Multiple
SDE Multiple = 670,000 X 7.7
SDE Multiple= $5,159,000
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. Business valuation companies recommend using EBITDA to determine a business’s financial performance based on the profits generated from its core operations.
By excluding non-operating expenses, EBITDA provides a clearer perspective of a business’s profit-generating ability. Even better, the obtained EBITDA value is independent of the financing option and the management’s accounting decisions, providing a more reliable metric for assessing a company’s operational performance.
The best use case for EBITDA is calculating business valuation for companies that generate over one million in annual revenue.
Here’s a simple formula to calculate a business’s EBITDA:
EBITDA = Net Income + Loan Interest + Tax Liabilities + Asset Depreciation + Amortization
Scenario: You want to conduct a SaaS valuation for a company with the following financials:
EBITDA = $50,000,000 + $2,000,000 + $10,000,000 + $500,000 + $500,000
EBITDA = $63,000,000
This multiple helps you calculate how much your business is worth based on EBITDA. Usually, there is no one-fits-all EBITDA multiple when determining a business’s value.
However, many M&A experts consider an EBITDA multiple of 8 as the benchmark, but it varies depending on the industry.
Below is a list of EBITDA multiples for various sectors:
Industry
Average EBITDA
Consumer Goods
12.8
Energy
14.7
Fintech
13
Healthcare
13.7
Hospitality
15.9
Manufacturing
6.8 - 11.2
Telecommunication
13.6
Source: First Page Sage and NYU Stern
The table below summarizes the main characteristics of SDE and EBITDA, including the best scenarios for using either method:
SDE
EBITDA
Purpose
Calculates the total available cash flow to the owner-operator.
Determines a company’s operating profitability notwithstanding its financing structure.
Owner Adjustments
Accounts for the owner’s compensation package and discretionary expenses.
Does not include the owner’s compensation or personal lifestyle expenses financed by the business.
Scale
Used for small-sized firms with less than $1,000,000 in earnings.
Used for medium and large-sized companies with more than $1,000,000 in revenue.
Financial Transparency
Not fully transparent as the discretionary expenses are included but the details might not be disclosed.
Prioritizes financial transparency to give prospective investors a clear picture of a business’s financial health.
Stakeholder Perspective
Relevant to investors buying small businesses as single owner-operators.
Preferred by institutional investors, such as banks, credit unions, hedge funds, and venture capital funds.
Application
Best for valuing small businesses where the owner doubles as the operator.
Best for medium and large companies where the management team is separate from the investors (owners).
Inclusion of Costs
Includes costs associated with the owner’s compensation and perks.
Focuses on the company’s operating expenses.
Accounting Standards
Not standardized, as the calculations rely on the owner’s discretion when disclosing compensation and personal lifestyle expenses.
Uses a standardized accounting method that enhances comparisons among various investment options.
Tax Considerations
Includes tax implications tied to the owner’s compensation and discretionary spending.
Excludes tax implications related to the owners’ personal expenses.
Cash Flow Consideration
Highlights the available cash flow to the owner-operator, providing a broader picture of a business’s cash-generating potential.
Focuses on the expected cash flow from a company’s core operations (operations profitability).
Complexity
SDE is more complex to calculate as it relies on owner-specific adjustments, which vary from one business to another.
Also, determining discretionary expenses is subjective, so the owner and prospective buyer might disagree on the costs to include or exclude.
EBITDA is more straightforward to calculate as the required metrics (interest, taxes, depreciation, and amortization) are derived from the company’s income statements.
Now that you know what SDE and EBITDA are and how they compare, you might be curious about your business's valuation. To streamline the process, we recommend working with business exit experts.
At Exitwise, we have helped 200+ founders and entrepreneurs recruit and manage expert teams to optimize their exit strategies. This enables you to exit a business quickly while also receiving the maximum financial gain.
Schedule a no-obligation call today to hire experts who will help you select the best-fit valuation method for your business!
Now that you know what SDE and EBITDA are and their use cases during business valuation, it is easy to identify their similarities and differences.
Let’s compare them below:
Here are the main differences between SDE and EBITDA:
While SDE and EBITDA are applied to businesses of different sizes, they share several similarities:
Net Operating Profit After Taxes (NOPAT) helps calculate a business’s expected after-tax income if there is no debt to service. It is derived by subtracting income tax from earnings before income and tax (EBIT).
The formula for calculating NOPAT is as follows:
NOPAT = EBIT (1-T) where T = percentage tax/100
Scenario: You want to determine NOPAT for a business with an EBIT of $15,000,000 and a 33% tax rate.
NOPAT = $15,000,000 (1-33/100)
NOPAT = $15,000,000 (1-0.33)
NOPAT = $15,000,000 (0.67)
NOPAT = $10,050,000
Some parties criticize NOPAT, considering most businesses have some form of debt in their capital structures.
However, debt repayment structures are discretionary and vary from company to company, impacting the income after interest.
For this reason, omitting loan interest when calculating NOPAT helps create an “apples to apples” scenario when comparing businesses in the same industry.
This section answers common questions about SDE and EBITDA when conducting a business valuation:
Use SDE for small, owner-operated businesses where the founder is central to its day-to-day operations. SDE is also a good performance metric when accounting for discretionary expenses like personal vehicle, traveling, and housing costs, which are not included in EBITDA.
In contrast, use EBITDA when assessing a medium-to-large business where operational profitability is a significant focus area.
EBITDA is the preferred valuation method for large businesses as it provides a standardized, comparable measure of profitability.
It also focuses on a company’s operational performance, including scalability and financial health, independent of its current owners.
SDE provides a more objective assessment for small businesses. It helps account for the owner’s influence on the expected revenue.
Additionally, SDE creates a clearer picture of what the new single owner-operator should expect from the business, including the cash flow, salary, and any discretionary or personal lifestyle perks.
With SDE, debt service is included during adjustments as the paid interests are part of the cash flow available to the single owner-operator. Also, SDE assumes that some of the debt service is tied to the current owner’s discretionary expenses, which may not apply post-sale.
Interest expenses and principal repayments are excluded when calculating EBITDA as they do not impact a company’s operating earnings. This ensures the calculated EBITDA reflects a company’s ability to generate profits regardless of its capital source.
Yes, you can use SDE and EBITDA together, though it is not common practice. The metrics assess different aspects, giving a holistic perspective of a company’s performance.
For example, you can calculate EBITDA to determine a business’s ability to operate profitably and SDE to evaluate the prospective buyer’s expected cash flow.
The valuation method you choose should match your business size and niche to ensure the findings are objective and reliable. Otherwise, you risk misrepresenting your business's valuation, which can hurt your negotiation leverage.
At this point, you know that SDE is best suited for small businesses, while EBITDA applies to entities that generate over one million dollars annually.
However, if you are unsure how to conduct a business valuation, we recommend outsourcing to professionals. At Exitwise, we help investors, business owners, and founders hire and collaborate with M&A teams to undertake business valuation or plan an exit strategy.
Book a free consultation to learn how our experts can help you maximize your business valuation and exit profitably!
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