How Small Businesses Are Valued: Understanding SDE Multiples

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👋 Hey fellow searchers,

Valuing a small business can be complex, especially when determining its true earning potential. One of the most commonly used metrics in this process is Seller’s Discretionary Earnings (SDE). In this issue, we’ll delve into what SDE is, why it’s preferred for small business valuations, how it’s calculated, and how it differs from other metrics like EBITDA.

What is SDE?

SDE represents the total financial benefit a single full-time owner-operator derives from their business annually. This metric is particularly useful for small businesses where the owner’s involvement is integral to operations.

Why is SDE Preferred for Small Business Valuations?

SDE is favored in small business valuations because it provides a clearer picture of the actual earnings available to a new owner-operator. By normalizing earnings to reflect the owner’s benefits and discretionary expenses, SDE offers a standardized measure that facilitates comparisons across similar businesses.

How is SDE Calculated?

Calculating SDE involves adjusting the business’s net profit by adding back expenses that are discretionary or specific to the current owner. The formula is:

📌 SDE = Net Profit + Owner’s Salary + Depreciation + Amortization + Interest Expense + Owner’s Benefits + Non-Recurring Expenses

Example Calculation:

• Net Profit: $100,000

• Owner’s Salary: $80,000

• Depreciation and Amortization: $20,000

• Interest Expense: $10,000

• Owner’s Benefits: $15,000

• Non-Recurring Expenses: $5,000

SDE = $100,000 + $80,000 + $20,000 + $10,000 + $15,000 + $5,000 = $230,000

This provides a clear, standardized number that potential buyers can use to assess profitability.

SDE Multiples: How They Determine Business Value

To estimate a business’s value using SDE, a multiple is applied to the SDE figure. The multiple typically ranges from 1 to 4 for small businesses, but choosing the right multiple depends on several factors:

✔️ Size of SDE – Higher-earning businesses command higher multiples. A business with $200K in SDE may sell for 2-3x, while one with $750K+ in SDE could see multiples of 3-4x.

✔️ Industry Trends – Some industries naturally attract higher multiples due to growth potential, stability, or recurring revenue (e.g., healthcare, B2B services).

✔️ Business Strengths – Companies with strong management teams, low customer concentration, or proprietary products are valued higher.

✔️ Market Conditions – A seller’s market (high demand, low supply) can push multiples higher, while economic downturns may compress valuations.

Example Valuation:

• SDE: $230,000

• Multiple: 2.5x

💰 Estimated Business Value = $230,000 × 2.5 = $575,000

However, if this business had recurring revenue, strong margins, and a well-documented operating system, it might receive a higher multiple of 3.5x, increasing its valuation to $805,000.

Choosing the correct SDE multiple is both an art and a science, requiring a mix of financial analysis, industry benchmarks, and market trends.

Final Thoughts

Understanding SDE and its multiples is crucial for valuing small businesses correctly. Whether you’re a buyer looking for fair pricing or a seller preparing for an exit, knowing how SDE is calculated and how to determine the right multiple can help you negotiate smarter deals. By analyzing financials, considering market trends, and applying the right SDE multiple, you can ensure you’re making an informed decision in any SMB acquisition.

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DISCLAIMER: This newsletter is for informational purposes only and should not be considered financial advice. It offers analyses of businesses without endorsing any specific financial actions. Readers are advised to do their own research and consult a professional before making investment decisions.