If you’re looking to buy or sell a small business, chances are you’ve come across the terms ‘SDE’ and ‘EBITDA’, along with many more.
Business brokers or experienced investors can mention them in a sentence assuming you know what they mean, quickly moving on to other topics.
Whether you are a buyer or a seller, it’s important that you know the difference, fully aware of their subtleties.
In this short article, I’ll walk you through the difference between these two terms, along with some other common terms around adjustments and add-backs, all of which can affect the way in which businesses can be valued.
EBITDA is short for earnings before interest, taxes, depreciation, and amortization and it is a method that is commonly used to measure the financial performance of a company.
It is generally used by private equity groups when evaluating larger businesses, but it’s still just as relevant for small businesses.
What Is EBITDA Used For?
The goal of this metric is to be able to value a business without taking into account the things that can affect how profitable it is.
It helps to provide investors and owners an objective view of the asset, allowing them to make a better valuation.
Does EBITDA Include Salaries?
Almost always, yes! When valuing larger companies, investors don’t tend to want to run the company themselves. This means they want to see all team members paid a salary.
Even if the current CEO is the sole shareholder, they will want to see that they are paid a market rate. This is a genuine operating expense, as they need to continue paying a CEO to run the company after they acquire it.
Example EBITDA Calculations
If you’re an experiential learner like me, sometimes it’s easier to understand concepts by seeing some examples.
Below I’ll do my best to show you some scenarios where EBITDA shows a clear difference.
Example 1: Corporate Taxes
Consider two online businesses that are identical in every way, the only difference is the country in which they are incorporated. One is registered where I live in Andorra with a corporate tax rate of 10%, while the other is in Australia where it pays 30%.
|Andorran Company||Australian Company|
|Cost of Goods Sold||$3,250,000||$3,250,000|
|Earnings Before Taxes||$5,250,000||$5,250,000|
At face value, quickly looking at an income statement, the business in Andorra will seem to be more profitable, with a Net Income that is $105,000 higher than the Australian Company.
But using EBITDA you can take an objective look at both companies. Here you can discover that that the Australian company is just as sound as the one in Andorra, the only difference is the tax rate.
The Aussie company could even be a greater opportunity due to this perception issue, where you can buy it for a lower valuation, only to re-domicile it to a more business-friendly country.
Example 2: Interest Repayments
In this scenario, the two businesses are similarly identical. Same revenue, same salaries, same margins, same tax domicile, and regime.
No Debt Ventures LLC is wholly owned by the shareholders, and only ever has a few small credit card repayments to make.
Max Leverage LLC has a huge chunk of debt on its balance sheet, so it needs to make some hefty loan repayments each year.
|No Debt Ventures LLC||Max Leverage LLC|
|Cost of Goods Sold||$3,250,000||$3,250,000|
|Earnings Before Taxes||$5,200,000||$3,250,000|
Again we can see that if only paying attention to Net Income, one company looks much better than the other.
But if an investor with the capital comes in to buy the business with cash, there’s no reason why Max Leverage LLC cannot give the buyer the same profit No Debt Ventures LLC.
SDE stands for seller’s discretionary earnings.
While SDE is also used to measure a business’s financial performance, it’s more in the context of an owner-operated business.
In small businesses, it’s not uncommon for the CEO, founder, owner, or whatever they choose to call themselves, to be remunerated in creative ways. These are known as ‘discretionary expenses’.
Sometimes this is aimed to reduce their tax liabilities, other times it’s because they aren’t confident in the revenue their business will produce, and often it’s just because they don’t know any better, or it’s an afterthought.
A small business owner may only pay themselves a small monthly salary but any time they travel, the business pays for it. They may pay for club memberships, coaching, fuel expenses, home internet, and mobile phone.
Then at the end of each year, a large dividend or ‘sales bonus’ is sent to them, along with a donation to a charity that they believe in.
These amounts may have lots of different names and line items in an income statement, but in the end, it’s all a benefit to the owner. It’s all SDE.
What Is SDE Used For?
Seller’s discretionary earnings aim to find the total financial benefit that is seen by the individual who is both the business owner and operator. The amounts you’ll see above, such as club memberships or coaching are listed as ‘add-backs’ on the income statement, so a buyer can see that total benefit in clear numbers.
It’s common to see SDE used on businesses that are owned and operated by a husband and wife team, or that may be acquired by an owner-operator. For this reason, it’s often applied to small businesses under $5M in revenue and is regularly used in the valuation of websites and other online business models.
This is useful to buyers who will choose to remunerate themselves differently from the current owner. Let’s look at an example of how SDE can provide a clearer picture.
Example SDE Calculation
Income statements outlining SDE seem to vary enormously, probably due to the fact that small businesses are producing them.
Below you can see an example of how SDE can be calculated.
|Cost of Goods Sold||$1,275,000||–||$1,275,000|
|Phone & Internet||$3,500||$1,250||$2,250||Personal Phone|
As you can see, the SDE calculation above uncovers $137,500 worth of additional financial benefit that an owner-operator receives. When small businesses multiple this amount for a valuation, it can make a big difference to the total sale amount.
Adjusted EBITDA vs SDE
If you’re positioning your business for a sale and speaking with different online business brokers, you will find that some choose EBITDA, while others opt for SDE. Both will regularly use ‘add-backs’ in their calculations.
To make things even more complicated, some use terms like ‘adjusted EBITDA’, only to confuse things further. It’s vaguely accepted that ‘adjusted EBITDA’ adds back any excessive salary and benefits paid out to the owner, that is more than a manager would make.
The problem with all these different terminologies is, there’s not a rule book that ensures everyone around the world makes these calculations in the exact same way.
So while your local CPA certification may agree on one method, as business becomes global, that becomes less and less relevant.
EBITDA by nature is adjusted, removing interest, tax, and so on. SDE is adjusted as well. As you throw add-backs into the mix, the numbers become adjusted even further.
For this reason, if you’re looking to buy a small business or invest in one, it’s worth looking through plenty of income statements before making any offers, as you’ll begin to learn they aren’t all the same.
Which Method Is Better?
One of the big differences is that in EBITDA calculations, the manager’s salary isn’t added back. In contrast, when calculating SDE, the manager’s salary is added back.
In theory, SDE is better for individual buyers who plan to operate the business themselves, as it tells them what they can expect to earn by operating that business.
Compare that with EBITDA, which may be better for investors who plan to put an operator in place to run the business.
Have I missed anything? Is anything incorrect? If so, leave a comment as I really appreciate your feedback.