How to Calculate the Value of Your Small Business: A Step-by-Step Guide to SDE and Multiples

How to Get a Back-of-the-Napkin Valuation for Your Business

For the most part, small businesses sell for a multiple of what they earn. The earnings metric used is typically Seller's Discretionary Earnings (SDE) or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), depending on the size and ownership situation.

Seller's Discretionary Earnings (SDE)

Definition:
SDE is a measure of a business's financial performance, commonly used to value small businesses. It represents the total financial benefit a single, full-time owner-operator can expect to receive from the business in a year.

Formula:
SDE = Net Profit + Owner's Salary + Discretionary Expenses + Non-Cash Expenses (e.g., Depreciation) + One-Time or Non-Recurring Expenses

Key Notes:

• Discretionary Expenses: Costs that benefit the owner but aren’t essential to the business (e.g., personal car expenses, travel).

• SDE assumes the new owner will replace the existing owner and won’t need to hire a manager.

• Primarily used for small businesses with revenues typically below $5 million.

EBITDA

Definition:
EBITDA is a measure of a company’s profitability before accounting for interest, taxes, depreciation, and amortization. It’s often used to value medium to large businesses because it shows the business’s operational earnings regardless of financing or accounting decisions.

Formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

Key Notes:

• EBITDA is a more standardized measure than SDE and is widely used in mergers and acquisitions for businesses with more complex financial structures.

• Unlike SDE, EBITDA doesn’t include adjustments for an owner-operator’s salary or discretionary expenses. (This would be referred to as Adjusted EBITDA.)

Side Note: SDE is sometimes referred to as "Cash Flow" on listing platforms. While I’m not a fan of this term, many platforms define "Cash Flow" as essentially representing SDE. Stick with SDE for clarity.

Calculating Your Earnings

Now that we understand the earnings metric, how do we calculate your earnings to apply a multiple to it?

Businesses sell for a multiple of their earnings. For this example, we’ll use SDE.

If you want the most accurate valuation, you should analyze your previous three years of earnings. Most buyers and banks will do the same.

Pro Tip: To achieve the highest valuation, ensure your earnings over the past three years are consistent and show year-over-year (YoY) growth. A single good year won’t impress buyers or banks as much as a solid three-year track record.

Step 1: Calculate Your SDE

Review the last three years of your Profit and Loss (P&L) Statements. (Banks will use tax returns, but let’s keep it simple for now.)

Use the following formula:
SDE = Net Profit + Owner's Salary + Discretionary Expenses + Non-Cash Expenses (e.g., Depreciation) + One-Time or Non-Recurring Expenses

For each year, add the following to your Net Profit:

• Any owner salary or distributions.

• Any discretionary spending (e.g., personal auto, phone, one-off expenses).

• Any non-cash expenses (e.g., depreciation).

• Any one-time or non-recurring fees (e.g., legal expenses, unusual repairs).

Example

Let’s say your calculations for the past three years look like this:

• 2022 SDE: $550,000

• 2023 SDE: $578,000

• 2024 SDE: $606,000

Great! Your earnings show consistent growth.

Now, calculate the average of these three years:
(550,000 + 578,000 + 606,000) ÷ 3 = $578,000

Your 3-year average SDE is $578,000.

Step 2: Apply a Multiple

This is where things get interesting. The multiple can vary significantly based on factors such as:

• The size of your earnings.

• The industry you’re in.

• Revenue growth.

• Market demand.

• Other qualitative factors (e.g., location, customer base, intellectual property).

For businesses earning under $1 million, the multiple typically ranges from 2x to 4x, depending on the specifics.

Important Note: When you hear about industries selling for high multiples (e.g., HVAC businesses at 11x earnings), pay attention to the details. That 11x multiple likely applies to businesses earning millions annually. For small businesses, the size of your earnings is the main driver.

Example Valuation

Using a multiple of 3x for your business:

3-year average SDE: $578,000 x 3 = $1,734,000

Additional Factors

Keep in mind that many other variables can affect the valuation of your business, including:

• Tangible and intangible assets.

• Inventory.

• Furniture, fixtures, and equipment (FF&E).

However, this simple calculation provides a back-of-the-napkin valuation to estimate what your business might sell for.

Ready for a Full Valuation?

If you’d like a comprehensive valuation to see what your business could sell for, feel free to reach out to me directly. We would be happy to help!