What is EBITDA? What is SDE? The Cash Flow Proxy Question

In small business sales, most business sales are done as a multiple of the agreed cash flow of that business. What’s a multiple? If a business is generating $100,000 in annual cash flow, the buyer might pay a three times multiple (or 3x) for ownership of the future cash flows of that business and therefore pay the seller $300,000 for the company. Cash flow multiples are common for these transactions because the buyer wants to purchase the realized earning potential of the business, not the future potential (this is a big difference between startup transactions and small business transactions). The reason we said agreed cash flow is because cash flows are not a definitive value. While there are standard components of a cash flow calculation, adjustments are made by the sellers and buyers of the businesses and they must come to agreement for the transaction to occur. To understand this process, we must understand the most common cash flow proxies: EBITDA or SDE.

Seller’s Discretionary Earnings (SDE) and Earnings before interest, taxes, depreciation, and amortization (EBITDA) are both ways to think about cash flow to determine a transaction multiple. The formula for EBITDA combines the business seller’s cash flow statement and income statement and looks like this:

EBITDA = Earnings (Income Statement) + Interest Expense (Income Statement) + Taxes (Income Statement) + Depreciation and Amortization (Cash Flow Statement)

EBITDA is often used as a proxy for business cash flows because it removes some of the strategic decisions the sellers might have made (e.g., interest payments or tax payments are a strategic decision on how to finance and invest in the business) and shows the true cash flows the business could generate for the buyer. EBITDA is also commonly used in small and large M&A transactions, making it easier to compare the seller’s business across other businesses with similar sizes, sectors, geographies, etc.

Seller’s Discretionary Earnings or SDE takes the baseline work of EBITDA and adds back additional strategic decisions for small businesses, namely the decision of the owner on how to spend some of the earnings. SDE’s formula looks like this:

SDE = EBITDA + Seller’s Income + Seller’s Benefits + Discretionary Expenses

Like EBITDA, the seller’s decision on how much to pay himself or herself, what benefits (health insurance, etc.) he or she maintains, and some minor discretionary expenses (travel, meals, etc.) are all strategic decisions that might change with new ownership. Therefore, these are added back into the cash flow to give the seller and buyer a more accurate value of cash flows.

It is worth noting that this is only the starting point for cash flow discussions in a business sale. There are often adjustments made to EBITDA and SDE based on one-time investing or expense decisions that either the seller or buyer might ask to include or exclude. That’s a longer topic for another day. But, if you are looking to sell your business with an easy process, then contact us today to learn more about selling your business to Endurance Eagle.

If you’re looking for more reading on EBITDA and SDE see the CFI’s post or this fantastic post from Exit Strategies Group.