When it comes to selling your business, what's with all this SDE and EBITDA jargon?
Colette Kemp
Principal @ SureStep Business Advisors | Accredited Small Business Consultant ~ Helping hardworking small business owners sell their businesses to the right buyer for the best price.
All right, let's cut to the chase.
Business owners, you're all about the bottom line—revenue and profit, right? That's your bread and butter.
So, when it comes to selling your business, what's with all this SDE and EBITDA jargon?
Let's break it down in plain English. These terms are just fancy ways to measure your business's financial performance.
SDE (Seller's Discretionary Earnings) is like your business's true earning power, factoring in the owner's perks and one-time expenses.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) strips out those extras to give a cleaner picture of profitability.
Both are crucial for valuing your business, but they speak different languages. So, when you're ready to sell, understanding these can help you get the best deal.
But before we dive deeper into which is more relevant to you, the business owner, let's roll up our sleeves and understand a little more of the basics.
So... how are businesses valued?
Businesses are valued at a multiple of SDE or EBITDA to offer a comparable, normalized measure of earnings potential. These metrics adjust for unique owner expenses and focus on core operational profitability, making it easier to benchmark value within an industry. Multiples also account for expected growth and risk, aligning the valuation with market standards for similar businesses and ensuring buyers see a fair representation of income potential.
But why are they valued at a "multiple" of SDE or EBITDA and not just at a price that the owner finds acceptable?
Using a multiple rather than a number set by the owner creates a valuation based on market-driven standards rather than personal preference. Multiples anchor the valuation to a company’s actual earnings potential, adjusted for industry norms and growth expectations. This approach provides buyers with a fair, transparent way to assess value and ensures the price aligns with comparable businesses, making it easier to justify the investment. An owner-chosen price, on the other hand, can lack the objectivity and market-based justification that multiples provide.
And... if sale prices were set purely by the business owner, it would not allow a buyer to be able to service the debt [money they borrow to finance the deal].
Setting a price without using a multiple can lead to an inflated valuation, which may make it difficult for the buyer to cover debt service from the business’s cash flow. A market-based multiple ensures the business’s earnings can reasonably support the buyer’s financing costs, providing a safer, more sustainable investment. By tying valuation to actual earnings potential, multiples help protect buyers from overpaying and create a realistic path to profitability post-acquisition.
OK, we can all breathe a little easier, having got all that out of the way!
Next, let's dive into the nitty-gritty of SDE and EBITDA. We're going to break down what makes these financial metrics tick and why they matter when you're selling your business.
The SDE multiple is typically lower than the EBITDA multiple in business valuations.
Why is that?
There are several reasons:
1. Inclusion of owner's compensation: SDE includes the owner's salary and benefits, while EBITDA does not. This means the SDE figure is usually higher than EBITDA for the same business.
2. Different target markets: SDE is typically used for valuing smaller businesses where the owner is actively involved in operations. EBITDA is more commonly used for larger businesses and corporations.
3. Assumptions about management: SDE assumes the buyer will be an owner-operator, while EBITDA assumes the business can be run by hired management.
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4. Working capital considerations: EBITDA multiples often include normal working capital in the purchase price, while SDE multiples typically do not.
5. Size of businesses: SDE is generally used for businesses with earnings under $1 million, while EBITDA is used for businesses with earnings over $1 million. Larger businesses tend to command higher multiples. **Earnings represent the net income or profit that a company produces after subtracting all expenses, including costs of goods sold, operating expenses, interest, and taxes, from its total revenue.
6. Investor expectations: EBITDA is often used by investors looking for a return on investment without active involvement, which can lead to higher multiples.
7. Risk perception: Smaller businesses valued using SDE are often perceived as riskier investments, leading to lower multiples.
8. Market conventions: By convention, the markets for smaller and larger businesses have developed different expectations for multiples based on these metrics.
For example, while SDE multiples might typically range from 2-3x (sometimes up to 4x for larger small businesses), EBITDA multiples for mid-sized businesses can range from 4-7x or higher depending on the industry and other factors.
Understanding these nuances can help you, as a business owner, better prepare for a valuation, make informed decisions about building value, and navigate the selling process more effectively.
If you're still with me and your eyes aren't glazed over like a donut, congrats! You made it through the nitty-gritty. Hopefully, you picked up some nuggets of wisdom along the way.
Got questions? Contact me anytime...
Email me at [email protected] or just call or text at 804-557-3557.
Happy to chat!
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