Businesses exist to make a profit for their Shareholders. Profit is also known as income or earnings for large-cap public companies. There are three terms that represent the concept of profit and it is critical small businesses understand the difference. Profit or earnings can be expressed as Net Income, EBITDA (Earnings before Income Taxes and Depreciation) and SDE (Seller Discretionary Earnings).
Net Income also known as bottom-line is the most commonly used metric to quantify profit for middle market and large cap companies. It can be easily found on the Income Statement. However, Net Income (NI) provides a skewed picture for small business that may be owner operated. Typically, small businesses want to reduce taxes, so they maximize expenses to reduce their EBIT (Earnings before Interest and Taxes). As such, Net Income is not a good metric for small businesses.
Another metric for profit commonly used by large and middle market companies and private equity groups is EBITDA. Private equity groups like to use EBITDA because it is a quick approximation of the businesses operating cash flow. EBITDA is also useful for larger businesses because it expenses the management and operations. Private equity groups do not get involved in day to day management of the company, so it is important to factor in management cost. The rationale that makes EBITDA good for mid to large companies is what makes it bad for small businesses, where the owner expenses must be added back to EBITDA get a true picture for earnings.
Seller’s Discretionary Earnings (SDE) is the mostly widely used metric for small business valuation. SDE represents the earnings of a small business more accurately because it makes adjustments for owner operator expenses. The simplest way to conceptualize SDE calculation is by taking the EBITDA and recasting owner expenses. Owner’s expenses must include owner’s salary, bonus and all benefits. The technique may be used to roughly estimate the SDE for a small business. Conversely, one can conceptually go from SDE to EBITDA by subtracting owner’s expenses. So, EDITDA = SDE – (Owner’s Salary + Benefits) and SDE = EBITDA + (Owner’s Salary + Benefits). When SDE is used with a multiple to value a business it’s called multiple of discretionary earnings. Multiple of discretionary earnings are best suited for owner operated businesses. Besides buying and selling businesses, SDE is also useful for comparing businesses. Seller’s Discretionary Earnings (SDE) is also sometimes called Seller’s Discretionary Cash Flow.
Business deals on the main street (0 – $2 Million) are typically based on SDE. Business deals in the lower middle market ($2 Million – $5 Million) are usually based on EBITDA. For vast majority of main street businesses working capital is not included in the value of the business.
There are several techniques to business valuation including asset based methods, earnings based methods and market based methods. Rule of thumb based valuation of a business is typically a multiple of SDE or EBIT. The multiplier for your business depends upon several factors including sector, industry, location, deal-size, deal structure, economic climate, financing, number of buyers and so on.
Please note / Disclaimer: Business owners must work with a business professional such as a business broker or chartered accountant (CA) to get an exact estimate for their business. The techniques described here is for business owners to conceptually understand Seller’s Discretionary Earnings (SDE), which plays a critical role in business valuation.