SDE and EBITDA explained with worked examples

The accounts of a small, owner-run business are prepared for tax and for the owner, not for a buyer. They usually include:

• the owner's own pay, often set for tax reasons rather than at what the job is worth
• interest, which depends on how this owner chose to finance the business
• depreciation and amortisation, which spread the cost of past purchases over time and are not cash spent in the year
• costs that will stop when the owner leaves, such as a family car or a one-off legal bill

In many countries an owner-director draws a modest salary and takes the rest as dividends or drawings, which never appear as a cost. Other owners pay themselves generously. Either way, net profit before tax is a poor guide to what you would earn after buying.

Restating the figures, often called normalisation, strips out those owner-specific items so that businesses can be compared on the same footing. The catch is that every restatement is also a chance to flatter the number. Knowing exactly how each figure is built is your first defence.

SDE answers a simple question. If you bought this business and ran it yourself, how much would it produce for you each year, before financing costs and before tax?

Loupe builds SDE from the accounts in this order:

1. Net profit before tax.
2. Add the salary and benefits of one full-time working owner.
3. Add interest.
4. Add depreciation and amortisation.
5. Add one-off or discretionary costs that a new owner would not carry, where they can be evidenced.

A few rules keep the figure honest. Only one owner's pay is added back. If two owners both work in the business, the second owner's pay stays in costs, because you would have to replace that person. Interest is added back because your financing will differ from the seller's, but any loan you take out will be repaid from the same earnings. Depreciation is added back because it is not a cash cost in the year, yet the vans and machines it relates to will still need replacing.

SDE is the usual measure for smaller businesses where the buyer expects to work in the business, often full time.

Pinewick Pool Care is a fictional pool maintenance business in the United States with revenue of $900,000, four technicians, three vans and one owner who works full time. All names and figures are invented.

The seller also wanted to add back $15,000 of "marketing that did not work" and $6,000 for the owner's mobile phone and home broadband. Neither is included above. Marketing is a normal running cost even when a campaign disappoints, and whoever runs the business will still need a phone.

SDE of $244,000 is what the business produces before paying you, before repaying any money you borrow to buy it, before tax and before you replace the vans. It is a starting point, not take-home pay.

EBITDA stands for earnings before interest, tax, depreciation and amortisation. Taken straight from the accounts, it is net profit before tax with interest, depreciation and amortisation added back. Adjusted EBITDA goes two steps further: it adds back evidenced one-off and discretionary costs, and it replaces whatever the owner was paid with a market salary for the job the owner actually does.

Loupe calculates it the simple way: adjusted EBITDA is SDE minus the market salary for the owner's role. Starting from net profit instead gives the same answer, because SDE has already added the owner's actual pay back in.

The market salary should be what it would cost to hire someone capable of doing what the owner does, including benefits and the employer's payroll taxes (employer's National Insurance in the UK). Be realistic about the role. An owner who sells, manages the team and keeps the books may be doing more than one job, and replacing them could cost more than one salary.

Back to Pinewick Pool Care. Suppose an operations manager who can run the crews and look after customers would cost $85,000 a year including benefits, a figure invented for this example.

If you are an investor who will not work in the business, such as a family office or a private equity firm, you will have to pay someone to do the owner's job, so adjusted EBITDA is your real starting point. Even if you plan to run the business yourself, your time has a cost, and adjusted EBITDA shows what the business earns once that cost is counted.

Fernhollow Joinery Ltd is a fictional UK maker of fitted kitchens with revenue of £4,000,000 and 35 staff. Two owners work in it: one is managing director, the other runs the workshop. All names and figures are invented.

Three points are worth drawing out.

First, the second owner draws £65,000 for running the workshop. That pay stays in costs, because a buyer would need a workshop manager. If the market rate for that job were higher, a careful buyer would deduct the difference as well. Loupe's valuation tool keeps pay for additional working owners in costs as it is, so check whether that pay is realistic yourself.

Second, the redundancy costs are only one-off if the showroom stays closed and its sales have already dropped out of the figures. If the year still includes several months of showroom sales, future revenue will be lower too, and the adjustment would overstate earnings.

Third, the managing director's market salary is higher than what the current owner draws. That is common. Owners of profitable companies often pay themselves less than the job is worth, which makes the adjusted figure lower than a quick reading of the accounts suggests.

At this size, adjusted EBITDA is also the figure Loupe's valuation tool would use. Converted to US dollars, £630,000 of adjusted EBITDA is above the USD 500,000 threshold described in the next section.

Use the one that matches how you will own the business, and look at the other as a check.

• If you will run the business full time yourself, SDE is your starting point. It has to cover your living costs, any loan repayments and the replacement of worn-out equipment.
• If you will employ someone to run it, or you are buying as an investor, start from adjusted EBITDA.
• For larger businesses, adjusted EBITDA is the norm, because they usually have management in place and attract buyers who will not run them day to day. In the Market Pulse survey by the International Business Brokers Association and M&A Source, deals under $2 million in purchase price are reported as multiples of SDE, and deals from $2 million to $50 million as multiples of EBITDA.

Loupe's valuation tool follows a similar rule. It values a business on adjusted EBITDA when adjusted EBITDA reaches USD 500,000 or SDE is above the tool's SDE ceiling, which is USD 750,000 by default, and on SDE otherwise. SaaS businesses with annual recurring revenue are valued on an ARR multiple, cross-checked against an SDE multiple. If an EBITDA-based value is needed and you have not entered a market salary for the owner's role, the tool asks for one rather than guessing. The methodology page sets out the full rules.

The multiples are not interchangeable. For the same business, SDE is the larger figure, so an SDE multiple is lower than an EBITDA multiple for the same price. Take an illustrative price for Pinewick Pool Care of $610,000. That is 2.5 times SDE of $244,000, but about 3.8 times adjusted EBITDA of $159,000. If one listing quotes a multiple of SDE and another a multiple of EBITDA, convert them to the same basis before you compare them.

SDE and adjusted EBITDA are useful for comparing businesses. Neither is the cash you will have in your pocket.

• Replacement spending. Depreciation is added back, but equipment still wears out. Deduct a realistic yearly figure for replacing vehicles, machines or software. See deferred maintenance or capital spend.
• Working capital. A growing business ties up more cash in stock and in money owed by customers before it is paid.
• Tax. Both figures are before tax.
• Loan repayments. If you borrow to buy, repayments come out of these earnings. Lenders look at debt service coverage: the earnings available to repay a loan divided by the yearly repayments. Loupe's affordability check uses earnings after a market salary for the owner's role for this, and compares the result with a threshold of 1.25 times by default.
• Quality. Both figures are only as good as the records and the add-backs behind them. See large or undocumented add-backs and tax returns that do not match the accounts.

A rough picture for Pinewick Pool Care, using invented figures, shows the gap. From SDE of $244,000, take $30,000 a year for replacing vans and equipment and $90,000 of yearly repayments on an acquisition loan. That leaves $124,000 before tax to pay yourself and to cover anything unexpected. The business is the same; the figure that matters to you is much smaller.

Unusually high margins deserve a second look too. Loupe's valuation tool flags a profit margin above 50% outside software and content businesses. See margins far above industry norms.

You do not need to be an accountant to test a seller's figures, though for a larger purchase a quality of earnings review by an independent accountant is worth considering. A practical order:

1. Ask for the accounts and tax returns for the last three years, management accounts for the trailing twelve months and the seller's schedule of add-backs.
2. Start from net profit before tax in the accounts and check that it reconciles to the tax returns. Taxable profit is rarely identical to accounting profit, so ask for an explanation of any difference.
3. Rebuild SDE line by line. For every add-back, ask for the evidence: invoices, payroll records, bank statements or agreements.
4. Decide on a market salary for the owner's role based on what the owner really does, not on their job title.
5. Compare your figures with the listing. Ask the seller to explain every difference.

Add-backs: which hold up and which do not goes through the common add-backs one by one, and the diligence document request list sets out what to ask for. When you have figures you trust, the free valuation tool shows both the earnings build-up and an indicative range. Treat all of this as general information, and take advice from a qualified accountant on the business you are buying.