SDE vs EBITDA

Ask yourself who is going to run the business on the Monday after close.

If the answer is you, use SDE. You are stepping into the owner’s chair, so the salary that owner was drawing becomes available to you. Adding it back tells you what the business will actually produce for you.

If the answer is a hired operator, use EBITDA. That operator has to be paid, so the owner’s salary is not a benefit you get to keep, it is a cost you have to replace.

That single assumption, whether you take over the day to day or hire someone to, is what separates the two measures, and it is the first thing we establish on a deal before presenting either.

It also explains why the two attract different multiples. SDE valuations run lower than EBITDA valuations, because SDE includes a benefit that only exists for an owner-operator.

The framing that lands best with buyers who have not done this before: EBITDA asks what the business earns as if the owner could leave it entirely alone and never hire anyone to fill the gap, the way a private-equity-owned business is expected to run. SDE asks what the business earns for someone who shows up and does the work.

Real deals rarely sit cleanly on one side. A business can be too big for pure SDE and too small to absorb a full management replacement salary.

When that happens we sometimes build an adjusted SDE rather than a straight EBITDA, because running it as EBITDA forces in a management replacement salary that may be far higher than what the business actually needs. On a deal where two owners are drawing significant compensation, the honest replacement cost is often around half of what they are taking, or a little less, and whether you model that in can decide whether the business clears a buyer’s target.

Two related asks come up repeatedly from buyers, and both are reasonable:

• Do not include short-term consulting engagements that end shortly after close, because those costs do not persist
• If the deliverable is presented as SDE, do not also include a replacement salary, because that double-counts the same job

Whichever measure you use, the presented figure and the diligence figure often differ, and the reason is usually structural rather than dishonest.

The two adjustments that move the needle most in our work are rent and insurance. If the seller owns the building, the rent on the books is whatever they chose to charge themselves, not what you will pay. We add back the seller’s rent entirely and substitute a fair market figure based on the lease you are actually going to sign. Insurance behaves the same way: a seller inside a large franchise group can carry cover priced far below what a new single owner will be quoted. We tell buyers to get their own insurance quote before we finish the report, because that number frequently comes back materially higher.

Unpaid roles are the third. Owners routinely do the bookkeeping and the HR without drawing a salary for it. That work does not disappear at close, so it has to be priced in.

It is worth being clear that this is rarely manipulation. On the deals where the number moves most, we typically find no purposeful misstatement and no deliberate overstating. What we find is the ordinary set of things most small businesses do, which happen to have a material effect on EBITDA and on the debt service coverage ratio, and which the seller had no particular reason to know how to present.

Worth knowing what that adds up to. Across our engagements, roughly 40 to 50 percent of deals come back within about five percent of the presented earnings. Around 30 percent land 10 to 15 percent off. The remaining 10 to 15 percent are materially off, by 20 to 30 percent or more. In one recent month we saw three separate deals come back more than 20 percent below the presented figure, which is more than we would normally see in a month, and a reason to approach current market numbers with some caution.