Understanding SDE: How It’s Calculated and Why It Matters in SMB Acquisitions
Feb 23, 2025
When evaluating SMB acquisitions, understanding financial metrics is crucial. One key metric often used is Seller’s Discretionary Earnings (SDE). Let’s delve into what SDE is, how it’s calculated, how it differs from EBITDA, and its role in SMB acquisitions.
What is SDE?
Seller’s Discretionary Earnings (SDE) represents the total financial benefit a single full-time owner-operator derives from a business annually. It’s also known as the “owner’s benefit” or “seller’s cash flow.” SDE provides a clearer picture of the cash flow available to a new owner by adjusting net profit to include the owner’s compensation and discretionary expenses.
How is SDE Calculated?
To calculate SDE, start with the business’s net profit and add back the following:
Owner’s Salary and Compensation: The total amount the owner pays themselves, including bonuses and benefits.
Discretionary Expenses: Costs that are not essential to business operations, such as personal travel, personal vehicle expenses, or non-business-related meals.
Non-Cash Expenses: Depreciation and amortization.
One-Time or Non-Recurring Expenses: Unusual or infrequent expenses that are not expected to continue in the future, like legal fees for a lawsuit or costs related to a natural disaster.
The formula is:
For example, a business with $150,000 in net profit, $80,000 in owner salary, $20,000 in discretionary expenses, and $10,000 in depreciation would have:
$150,000 + $80,000 + $20,000 + $10,000 = $260,000 in SDE
SDE vs. EBITDA
While both SDE and EBITDA measure a business’s profitability, they serve different purposes based on the type of buyer and business size.
SDE:
Includes the owner’s total compensation, discretionary expenses, and one-time costs.
Focuses on the total financial benefit for a single owner-operator.
Commonly used for smaller, owner-operated businesses.
EBITDA:
Focuses on operational profitability and excludes the owner’s salary and discretionary expenses.
Provides a clearer picture of the business’s performance as an independent entity.
Commonly used for larger businesses with earnings exceeding $1.5 million.
EBITDA Formula:
EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization
For example, if a business has a net profit of $200,000, interest expenses of $20,000, taxes of $30,000, and depreciation and amortization totaling $50,000, its EBITDA would be:
$200,000 + $20,000 + $30,000 + $50,000 = $300,000
SDE in SMB Acquisitions
In SMB acquisitions, SDE is a vital metric because it provides potential buyers with a clear picture of the cash flow they can expect if they take over and operate the business themselves. It reflects the total earnings available to an owner-operator, making it particularly relevant for individual buyers assessing the financial viability of a business.
SDE is also the basis for determining valuation multiples, which are used to calculate a business’s market value. For example, a business with $300,000 in SDE valued at a 3x multiple would have a valuation of $900,000.
Smaller Businesses (< $1M in Earnings): SDE is most often used for businesses with less than $1 million in annual earnings, as they are typically sold to owner-operators.
Larger Businesses (> $1.5M in Earnings): At higher earnings levels, EBITDA is used instead of SDE, as these businesses often sell to private equity groups or strategic buyers who focus on operational profitability over owner-specific benefits.
Final Thoughts
For SMB acquisitions, understanding and calculating SDE is crucial—it not only clarifies the true financial benefit of owning a business but also helps set accurate valuations. For smaller businesses, SDE will likely be the metric you encounter most often, while larger businesses shift to EBITDA as they target different types of buyers.
By grasping the nuances of these metrics, you’ll be better equipped to evaluate opportunities and make informed decisions in your acquisition journey.