If you want to sell your small business, chances are your valuation specialist will use a multiple of SDE to calculate its value. But how are these multiples found and how can you estimate one for your business?
At MidStreet, we commonly use seller’s discretionary earnings (SDE) as a method to value the businesses we sell. For businesses with over $1 million in earnings, we use EBTIDA.
To help you understand how an SDE multiple factors into your business valuation, we will cover what it is, the ranges of SDE multiples, where they come from, why EBITDA multiple ranges are lower, and the criteria that raise or lower your multiple.
Let’s jump in.
The Definition of an SDE Multiple
To understand an SDE multiple, you first should know what SDE is. As we mentioned above, SDE means seller’s discretionary earnings.
To find your business’s SDE, a valuation specialist must find the earnings of your company before income tax, depreciation, amortization, interest, discretionary or recurring expenses, and one owner’s salary.
This will ultimately show the financial benefit of the business to one owner-operator. This is a common method for businesses earning less than $1 million per year in cash flow.
The SDE multiple is a number applied to the SDE that is found by analyzing averages in the industry and evaluating the unique qualities of the business.
The Ranges of SDE Multiples and How They Are Used
For each business size range, there is a common range of SDE multiples. However, not all companies will fall within these ranges, since they may be an outlier, either falling lower or higher than the average.
Since businesses routinely fall outside of these ranges, it is important for your valuation specialist to be familiar with your company. There is no way the value can be calculated accurately without them going through your financials and learning about your business.
Where Do SDE Multiples Come From?
To find an accurate SDE multiple for a business being valued, a valuation analyst will use comparable sales databases like PeerComps and BizMiner. These sites have data on business sales completed through the SBA 7(a) program.
The comps that are found and the way they are analyzed will dictate the quality of the multiples you find. To learn more about comps, read “What Are Comps and How Are They Used to Value Your Business?”
To view comparable sales of manufacturing businesses, download our sample comp report.
Why EBITDA Multiple Ranges Are Higher
EBITDA multiples are higher because EBITDA is inherently lower than Seller’s Discretionary Earnings. Because SDE adds back one full-time owner operator, it will usually be $75,000 - $200,000 higher than EBITDA when calculated properly.
In general, as the business size goes up, the chances of a buyer using EBITDA to value the business increases. For most businesses, EBITDA and SDE multiples will result in a similar value when applied properly.
If there is a large difference between SDE and EBITDA multiples, there is likely some error or outlier in the comparable sales. Typical EBITDA ranges for small businesses are hard to identify because most comparable sales sources use SDE and EBITDA calculations found in databases like BizMiner, PeerComps, and is often incorrect.
Imagine you see a business with $300,000 in SDE and $280,000 in EBITDA. In most cases, this won't make sense because the main difference in SDE and EBITDA is manager salary, which would only be $20,000 in this case. This is not a market rate manager salary for any industry.
You can sanity check the EBITDA multiples using SDE if you’re unsure if they’re realistic. You can also check them using a buyer test method if the deal is likely to go through the SBA. Any deal that will use the SBA 7(a) program should be valued using SDE because that is what the SBA lender underwriters will use.
What Criteria Lower Your SDE Multiple?
There are a variety of factors that can sway your SDE multiple higher or lower. Some things that lower your SDE multiple are:
- If your business hasn't been around for very long (less than 10 years)
- Your historical financials show inconsistent profitability
- There is no room for growth or improvement
- Your customer concentration is high (a customer makes up more than 20% of your revenue)
- You are critical to the daily operations
- Many of your team members are related to you
- There is a low barrier of entry for your industry
- Your equipment is old or not in great condition
- Your average employee tenure is short
- Your business is not in a growing or desirable location
If you improve these things in your business, you can generally increase the multiple you can sell your company for.
What Criteria Raise Your SDE Multiple?
Factors that will increase the SDE multiple you can receive include:
- Your historical financials show consistent profitability
- Your business has been around for over 10 years
- Your business is owner-absentee
- The service your company provides is in high demand
- You have a solid team of managers with good tenure
- Your business has low customer concentration
- Your equipment is in good condition
- Your company has good positioning in the market
- Your financial records are well organized
- Your business is in a desirable location
- You have a clear reason for selling (such as retirement)
These are just a few of the things that can positively impact the multiple you can sell for.
Understand The SDE Multiple You Can Sell For
By knowing what an SDE multiple is and what it is impacted by, you will be able to better control the multiple you will be able to sell your business for by preparing ahead.
Exit planning is the number one way to increase your multiple by setting goals of how you will improve the company before selling. Learn more about exit planning by reading “What is an Exit Plan? (And Why Every Business Owner Needs One).”