SDE vs Adjusted EBITDA: Understanding the Key Differences

When it comes to valuing businesses, two metrics often create confusion: Seller's Discretionary Earnings (SDE) and Adjusted EBITDA. While they might seem similar at first glance, understanding their differences is crucial for anyone involved in business valuation or M&A.

The Quick Take

• SDE: Used for small businesses where owners are operators ($2M earnings or less)

• Adjusted EBITDA: Used for larger businesses where owners are investors (Above $2M earnings)

Understanding the Basics

Both SDE and Adjusted EBITDA serve as the foundation for business valuation. They're typically multiplied by market multiples to determine a company's worth. For instance, if a company has an SDE of $400,000 and comparable companies trade at 3.0x, the valuation would be $1.2 million.

Adjusted EBITDA

What Is It?

Adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is the go-to metric for larger businesses. It aims to normalize earnings for comparison purposes. Unlike SDE, it excludes owner salary since it assumes operational management is handled by employees, not owners.

The Calculation

A typical Adjusted EBITDA calculation starts with Net Income and adds back:

1. Standard Items: (a) Interest (b) Taxes (c) Depreciation (d) Amortization

2. Discretionary Items: (a) Discontinued operations (b) One-time expenses

3. Transactional Items (a) Deal expenses (b) Management fees

4. Pro Forma Adjustments (a) Known future changes

SDE (Seller's Discretionary Earnings)

What Is It?

SDE is primarily used for small to medium-sized businesses. It represents the total financial benefit that a single, full-time owner-operator would receive annually. This includes profits, owner's salary, benefits, and personal expenses run through the business.

The Calculation

Think of SDE as "Adjusted EBITDA +" with this formula:

``` Net Income + Standard EBITDA Adjustments + Owner's Salary + Personal Expenses = SDE ```

Common SDE Add-Backs:

1. Officer's salary 2. Owner's payroll taxes 3. Personal expenses (phone, fuel, etc.) 4. Charitable contributions 5. Non-recurring expenses 6. Depreciation 7. Interest

When to Use Which?

The choice between SDE and Adjusted EBITDA typically depends on:

1. Business Size: Under $2M earnings → SDE Over $2M earnings → Adjusted EBITDA

2. Owner Involvement Owner operates day-to-day → SDE Owner is purely an investor → Adjusted EBITDA

Key Differences: SDE vs Adjusted EBITDA

The choice between SDE and Adjusted EBITDA comes down to one key question: Will the new owner need to be involved in day-to-day operations?

If yes → Use SDE If no → Use Adjusted EBITDA

Remember, there's no hard rule about when to use which metric. The $2M threshold is a guideline, not a requirement. The real determining factor is the level of owner involvement in daily operations.