For business owners considering an exit, understanding key valuation metrics like EBITDA and SDE is essential. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a key metric for gauging a company’s operational profitability by removing financing and accounting decisions. However, for valuation purposes, especially with small and lower middle-market companies, we also use SDE (Seller’s Discretionary Earnings). Both metrics are highly correlated with a company’s sale price.
Adjusted EBITDA is a standard measure of a company’s core operational performance. It shows the cash flow from core operations before the impact of capital structure (interest, amortization), income taxes, changes in net working capital, and capital expenditures (CapEx). The “adjusted” part is crucial; it normalizes earnings by removing one-time and non-recurring expenses or revenues.
SDE is essentially Adjusted EBITDA with a key addition: it includes one full-time owner’s salary, benefits, and any other verifiable personal expenses paid through the business. This ‘recasting’ of the financials provides a clear picture of the total cash flow available to a full-time, single owner-operator to cover their compensation, debt service, working capital, and capital expenditures.
We use these metrics to create an “apples-to-apples” comparison between companies of similar size and complexity.
Adjusted EBITDA is the standard for valuing larger, more complex businesses. It’s a clean metric that allows buyers to see the earning potential of the business regardless of how it’s financed or structured.
SDE is particularly useful for valuing small businesses and select lower-middle-market companies. Since an owner’s compensation and personal expenses can vary widely and often blur the lines between personal and business finances, recasting the financials to calculate SDE normalizes the earnings. This gives a prospective buyer a transparent view of the total cash flow available to pay themselves, service debt, and reinvest in the business.
Ultimately, while both metrics provide a foundational value, the choice of which one to use depends on the size and nature of the business, and a value derived from a valuation multiple is just one of several valuation methodologies employed. Understanding them is the first step toward a successful exit.
Feel free to reach out to discuss how these principles apply to your business.
