Unlocking Your Small Business Value: Why SDE is Your Valuation North Star (and When to Forget EBITDA)

If you’re a small business owner considering selling, you’ve probably heard the term “business valuation.” And if you’ve done even a little research, you might have stumbled into a confusing world of acronyms like SDE and EBITDA, often paired with eye-popping multipliers.

Here’s the truth: For businesses under $10 million in annual revenue – especially those that are owner-operated – trying to apply large-company EBITDA multiples can lead to wildly inaccurate expectations and a frustrating sale process.

At Surge Business Law, we believe in clarity. For the vast majority of small businesses, Seller’s Discretionary Earnings (SDE) is the most relevant and reliable valuation metric.

Understanding the Key Players: SDE vs. EBITDA

Let’s break down these two critical financial terms:

1. Seller’s Discretionary Earnings (SDE): The Owner’s Take-Home Value

Think of SDE as the total financial benefit an owner-operator receives from their business. It’s designed to show a prospective buyer what they could expect to earn if they stepped into your shoes.

SDE = Pre-Tax Profit + Owner’s Salary + Owner’s Perks/Discretionary Expenses + Interest + Depreciation + Amortization

Essentially, it takes the profit of the business and “adds back” expenses that are unique to the current owner, such as:

• Your own salary, wages, and health insurance: If you’re working in the business, your compensation is added back because a new owner will either pay themselves or hire someone to do your job.
• Non-operating or personal expenses: Things like a personal vehicle paid by the company, excessive travel, or even a spouse’s salary if they don’t perform a critical, market-rate role.
• One-time, non-recurring expenses: Large, unusual expenses that won’t happen again (e.g., a lawsuit settlement, a major equipment repair from an unusual event).
• Interest, Depreciation, and Amortization: These are typically added back, similar to EBITDA, as they reflect capital structure or non-cash accounting items.

SDE gives a clear picture of the total cash flow available to an owner-operator to cover their compensation, debt service, and any investment.

2. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): The Investor’s View

EBITDA is a measure of a company’s operating performance, typically used for larger businesses where ownership and management are separate. It shows profitability before the impact of financing decisions (interest), tax strategies, and significant capital expenditures (depreciation/amortization).

EBITDA = Revenue – Cost of Goods Sold – Operating Expenses (excluding D&A)

Or, from SDE, remember our earlier conversation:

EBITDA = SDE – (Owner’s Replacement Salary) – (Owner’s Perks/Discretionary Expenses)

The crucial difference here is the Owner’s Replacement Salary. For a small owner-operated business, the owner often performs multiple roles (CEO, sales manager, lead technician, marketing director). To calculate true EBITDA, you must subtract what it would cost to hire a manager or team to perform all those duties at a fair market rate.

Why You Should Focus on SDE (and Be Wary of High EBITDA Multiples)

This is where many small business owners get tripped up. Larger businesses (often over $5-10M in revenue, or those with significant management teams independent of ownership) are valued using EBITDA multiples, typically ranging from 3x to 7x (or even higher for very large, fast-growing companies).

The problem? If you calculate your EBITDA by simply adding back your salary and not subtracting a replacement salary for all your duties, you’re inflating your EBITDA. An accurate EBITDA for an owner-operator will often be significantly lower than their SDE.

Small businesses, especially those reliant on the owner’s day-to-day involvement, are rarely valued at 5-7x their SDE (or even their inflated EBITDA). The market simply doesn’t support it due to the inherent risk and reliance on a single individual.

Your Small Business Valuation Formula: SDE + Assets

For businesses under $10 million in revenue, our preferred and most realistic valuation approach is:

Business Value = (SDE x Factor) + Fair Market Value of Transferable Assets – Transferable Liabilities

Let’s break down this formula:

• SDE x Factor: This is the core operating value of your business.
• The Factor: This typically ranges from 0.8 to 1.2.

• 1.0: For businesses with stable, consistent revenue over the last three years.
• Above 1.0 (e.g., 1.1 or 1.2): If your business demonstrates strong, consistent revenue growth.
• Below 1.0 (e.g., 0.8 or 0.9): If revenue is declining or stalling, or if the business is heavily reliant on a few key customers.

• Fair Market Value of Transferable Assets: This includes tangible assets like equipment, vehicles, and salable inventory.
• Transferable Liabilities: This includes debts that a buyer would assume (e.g., equipment leases, specific business loans). Note: Accounts Payable and normal operating liabilities are typically managed in the transition and not usually part of the purchase price calculation itself unless specified.

This formula provides a much more grounded and defensible valuation for small, owner-operated businesses, directly addressing the value an owner brings and the tangible assets included in the sale.

Hypothetical Valuations Using Our Formula

Let’s see this in action with your examples:

1. The Charming Boutique

• Details: $400k Annual Revenue, $120k SDE (owner-operator), $30k inventory, $25k vehicle.
• Assumptions: Stable revenue (factor = 1.0), no significant transferable liabilities.
• Calculation:

• SDE Component: $120,000 x 1.0 = $120,000
• Assets: $30,000 (inventory) + $25,000 (vehicle) = $55,000
• Estimated Business Value = $120,000 + $55,000 = $175,000

2. The Efficient Service Business

• Details: $190k SDE (owner-operator, subs out most work), $60k trailer & equipment, no inventory.
• Assumptions: Stable revenue (factor = 1.0), no significant transferable liabilities.
• Calculation:

• SDE Component: $190,000 x 1.0 = $190,000
• Assets: $60,000 (trailer & equipment) = $60,000
• Estimated Business Value = $190,000 + $60,000 = $250,000

3. The Growing Small Manufacturer

• Details: $5M Annual Revenue, 2 owners combine for $400k (their “SDE”), $5M in Fixed Assets, $500k Inventory (wholesale value), $2M Liabilities, 20 Employees.
• Assumptions: Let’s assume consistent growth, so we’ll use a factor of 1.1. This is a larger small business, so while SDE is still relevant, the presence of 20 employees and active owner involvement might push the multiple slightly higher if truly growing.
• Calculation:

• SDE Component: $400,000 x 1.1 = $440,000
• Assets: $5,000,000 (Fixed Assets) + $500,000 (Inventory) = $5,500,000
• Liabilities: -$2,000,000
• Estimated Business Value = $440,000 + $5,500,000 – $2,000,000 = $3,940,000
• Note: For a business of this size, a buyer might look more closely at adjusted EBITDA, and the asset value plays a very significant role. The SDE multiple here is a smaller part of the total. This highlights how the formula adapts.

Ready to Understand Your Business’s True Value?

Accurately valuing your small business is the first step towards a successful sale. By focusing on SDE and understanding its nuances, you can set realistic expectations and position your business for a smooth transaction. Don’t fall into the trap of applying large-company metrics to your unique small business.

Frequently Asked Questions 

Why is an “Owner’s Replacement Salary” so important when discussing EBITDA?

For small, owner-operated businesses, the owner often performs multiple critical roles. SDE counts the owner’s total compensation as part of the benefit. To calculate a true EBITDA (which assumes an arms-length management structure), you must subtract what it would cost to hire a general manager or team to replace all the owner’s operational duties at a fair market rate. Without this, EBITDA is artificially inflated.

My business is growing very fast. Does that mean I can use a much higher multiplier?

Growth is definitely a positive factor! Our formula accounts for this by allowing the SDE factor to go above 1.0 (e.g., 1.1 or 1.2). While strong growth will certainly make your business more attractive and justify a slightly higher multiple on SDE, it’s rare for small, owner-operated businesses to command the very high multiples (5x-7x) seen in larger, venture-backed, or publicly traded companies. The inherent reliance on the owner still limits the multiple.

What if my business has a lot of debt? How does that affect the valuation?

The formula includes subtracting “Transferable Liabilities,” which explicitly accounts for debt that a buyer would assume. If you have significant business debt that a buyer won’t assume (e.g., you’re paying it off before sale), it won’t directly reduce the calculated value, but it will affect your personal net proceeds from the sale. A healthy balance sheet with manageable debt makes a business more attractive.

My business has very unique, specialized equipment. How is that valued?

Unique or specialized equipment is still valued at its “Fair Market Value.” This means what a willing buyer would pay for it in its current condition, taking into account its age, wear, and specific functionality. While it might be expensive to replace it with a new one, its market value used is what’s relevant for the valuation. In some cases, a third-party appraisal might be warranted.

What’s the difference between “inventory” and “assets” in the formula?

“Assets” in our formula refers to fixed, tangible assets such as equipment, vehicles, real estate (if included), and other long-term assets. “Inventory” (raw materials, work-in-progress, finished goods) is a separate current asset often valued at its wholesale or cost basis. We specify “transferable assets” to ensure clarity that only the assets changing hands with the business are included.