SDE vs. EBITDA: Which Earnings Number Buyers Actually Use

The earnings measure that applies to a business depends on who will buy it. An owner-operated company bought by an individual is valued on seller's discretionary earnings. A company large enough to run under hired management is valued on EBITDA. Applying the wrong measure, or mixing a multiple from one with earnings from the other, is one of the most common reasons owners arrive at a price the market will not support.

What each measure captures

Seller's discretionary earnings (SDE) is the total financial benefit available to one full-time owner-operator. It begins with pre-tax net income and adds back interest, depreciation and amortization, the owner's salary and payroll taxes, the owner's benefits, and expenses that are discretionary or non-recurring.

SDE answers a specific question: if I buy this business and run it myself, how much cash is available to pay me, service my debt and reinvest?

EBITDA is earnings before interest, taxes, depreciation and amortization. In a sale context it is usually adjusted EBITDA, which removes non-recurring items and replaces the owner's actual pay with a market-rate salary for a manager doing the same job.

EBITDA answers a different question: how much does this business earn after paying someone to run it?

The difference is the cost of management

The relationship between the two is simple. Adjusted EBITDA is approximately SDE less the market cost of replacing the owner.

Consider a company with SDE of $400,000 whose owner works full time as general manager. If a qualified manager would cost $110,000 in salary, taxes and benefits, adjusted EBITDA is about $290,000. Both figures describe the same business. They are simply stated from two different buyers' points of view.

Which one applies

Size and buyer type decide the question.

• Businesses with earnings under roughly $750,000 to $1 million are usually bought by individuals who will work in them. These buyers and their lenders think in SDE.
• Businesses with earnings above that range begin to attract strategic acquirers and investment groups that install or retain management. These buyers think in adjusted EBITDA.
• Businesses in between are often analyzed both ways, and the advisor's task is to identify which buyer group is likely to pay more.

There is no bright line. A $600,000 SDE business with a strong second-in-command may attract an EBITDA buyer. A $1.5 million EBITDA business that depends entirely on its founder may be treated like a much smaller one.

Why the multiples differ

SDE multiples are lower than EBITDA multiples, and owners sometimes read this as a penalty. It is arithmetic. Because SDE includes the owner's compensation, it is a larger number applied to a smaller multiple. EBITDA excludes that compensation, so it is a smaller number applied to a larger multiple.

Return to the example. At 2.8 times SDE of $400,000, the business is worth $1.12 million. At 3.9 times EBITDA of $290,000, it is worth $1.13 million. The two methods should arrive in the same neighborhood. When they do not, one of the inputs is wrong.

The error to avoid is borrowing a multiple from the wrong column. An owner who reads that companies in the industry sell for five times EBITDA, then applies five times to SDE, has overstated the value by a wide margin. Published multiples for larger companies also reflect scale, management depth and diversification that a small company does not have.

How lenders look at it

Most Main Street acquisitions are financed with bank debt, frequently an SBA 7(a) loan. The lender does not use a multiple at all. It asks whether the cash flow of the business, after a reasonable salary for the new owner, covers the proposed debt payments with room to spare.

Under current SBA rules, a first-time acquisition must show debt service coverage of at least 1.25 times, measured on historical or adjusted historical earnings. Projections cannot be used to meet the test. In practice this means the lender's view of cash flow sets a ceiling on price, whatever multiple the parties have in mind.

What this means for an owner

Three practical points follow.

1. Know which buyer you are likely to attract. That determines which measure will be used and what evidence will matter.
2. Document owner compensation fully. Salary, payroll taxes, health insurance, retirement contributions, vehicle and phone all belong in the SDE calculation, and each needs support.
3. Be honest about the replacement cost. If the owner works sixty hours a week across sales, estimating and operations, a buyer may need to hire more than one person. Understating that cost invites a correction later.

The measure itself does not create or destroy value. It is a common language. An owner who can present earnings accurately in both forms, and explain the bridge between them, is in a stronger position with any buyer who comes to the table.

Twelve31 Advisors prepares confidential valuations that present both measures and the market evidence behind them.