Both seller’s discretionary earnings and EBITDA are used by buyers to estimate the free cash flow produced by a company. Ultimately which number is used depends on who the likely buyer of the company is – this is most influenced by the size of the company. Seller’s discretionary earnings are intended to reflect the cash flow produced for an active owner. This is relevant to smaller companies, where it is reasonable to assume that the owner will be running the business on a day to day basis. Seller’s discretionary income effectively does not include a salary for that key position and assumes the owner will be the beneficiary of all the earnings of the company. In contrast, EBITDA should include all the expenses (including of management) to operate the business. This is a more accurate perspective for a financial buyer who does not intend to have an active roll within the business. There is no hard and fast rule about the size of the company that should be listed using SDE vs EBITDA, but in general under a million dollars of earnings should probably be listed using SDE. Over one million dollars in EBITDA will appeal to financial buyers such as private equity groups, family offices, and large strategic buyers.
Note, the use of SDE vs EBITDA should not impact the value of the firm. The multiples are different, but the difference in SDE multiples vs EBITDA multiples predominately reflects the increase in value for larger companies.
Part of our job at Black Iron Advisers is assessing the company and determining who are the most likely buyers. If we do this job correctly, we will be able to use the appropriate value in our presentation. For companies that may appeal to both types of buyers, we often prepare two complete confidential information memorandum (CIM). Using the appropriate value based on the type of buyer.