Picture two deals on the same business. The seller thinks it's worth $1M. The buyer calculates $700K. Neither is wrong on the math. They're just using different metrics — and neither of them realized it until the conversation had already turned sour.
That mismatch kills deals. It's also completely avoidable, as long as you understand the two earnings metrics small businesses are actually valued on — Seller's Discretionary Earnings (SDE) and EBITDA — and know which one applies to your business.
What SDE Actually Measures
SDE is Seller's Discretionary Earnings — the total cash flow available to an owner-operator. It's the money the business generates that ultimately lands in the owner's pocket, whether it shows up as salary, as personal expenses paid by the business, or as retained earnings.
The formula is straightforward:
SDE = Net Income + Owner Salary + Owner Personal Expenses + Depreciation
You start with net income from the tax return. You add back the owner's salary, because a new owner might pay themselves differently or hire a manager. You add back personal expenses the business paid — the company car, health insurance, phone, the portion of travel that's really personal. You add back depreciation, because it's a non-cash expense that doesn't affect what the business actually generates.
SDE is the metric for owner-operated businesses. It answers the question a buyer-operator is really asking: How much cash will this business put in my pocket if I buy it and run it?
What EBITDA Actually Measures
EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization — the operating profit of the business, stripped of financing decisions, tax structure, and accounting treatments.
The formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
You add back interest because the new owner might finance the business differently (or not at all). You add back taxes because tax structure varies by buyer. You add back depreciation and amortization because they're non-cash items that reflect accounting choices, not actual cash flow.
Notice what EBITDA doesn't add back: owner salary or owner personal expenses. That's intentional. EBITDA assumes the business has professional management being paid a market wage, and no discretionary owner spending in the P&L to begin with. It's the metric for professionally managed businesses.
When to Use Which
The dividing line is usually size and structure. SDE applies to owner-operated businesses, typically under $1M in revenue. You do the work. Customers buy from you. A buyer is stepping into a job as much as an investment. SBA loans use SDE exclusively — if your buyer is getting SBA financing, the valuation will be SDE-based.
EBITDA applies to larger, professionally managed businesses, typically over $1M in revenue. A manager or team runs day-to-day operations. The owner is passive or near-passive. Commercial lenders and private equity buyers default to EBITDA for anything north of $1M.
The crossover usually happens around $1M in revenue, but it's not a hard line — it's about whether the business actually runs without you. A $1.5M business where the owner still does 70 percent of the work is probably SDE-based. An $800K business with a real manager in place might be EBITDA-based.
Multiples also differ. SDE businesses trade at roughly 2x to 3.5x. EBITDA businesses trade at 3x to 5x. The multiples on EBITDA look higher, but remember — EBITDA itself is usually a smaller number than SDE on the same business, because it doesn't include owner add-backs.
The Same Business, Two Different Numbers
Here's what this looks like on a real P&L. A $600K revenue service company with $150K in net income on the tax return.
SDE calculation:
- Net income: $150K
- Owner salary add-back: $80K
- Personal expenses: $15K
- Depreciation: $5K
- SDE: $250K
At a 2.8x SDE multiple, that's a $700K valuation.
EBITDA calculation on the same business:
- Net income: $150K
- Interest: $8K
- Taxes (roughly 25 percent): $35K
- Depreciation: $5K
- EBITDA: $198K
At a 3.2x EBITDA multiple, that's a $634K valuation.
Same business, $66K apart. SDE is higher here because it captures the discretionary owner items that EBITDA doesn't. That's not a trick — it's a reflection of what each metric is designed to measure. SDE says: here's the cash an owner-operator will actually take home. EBITDA says: here's the operating profit of the business as a standalone entity.
The 20-40 Percent Swing
The choice of metric can create a 20 to 40 percent variance in valuation for the exact same business. On a million-dollar deal, that's a $200K to $400K gap — easily enough to blow up a negotiation that should have closed.
This is where deals fall apart. The seller builds expectations around an SDE-based valuation of $1.2M. A sophisticated buyer comes in with an EBITDA-based offer at $800K. Both sides think the other is being unreasonable. In reality, they're using different metrics and nobody called it out.
The fix is to establish the metric before negotiation starts. Know which one applies to your business. Document your methodology. Make sure every buyer — and every lender involved — is working from the same framework.
The Natural Progression
Most businesses transition from SDE to EBITDA as they grow and professionalize.
$300K to $600K in revenue: pure SDE territory. The owner is the business.
$600K to $1.2M: the transition zone. You might see both metrics used, often in parallel, depending on the buyer pool.
$1M and up: shifts to EBITDA, especially when there's professional management in place and commercial lenders are involved.
The transition matters because it forces a strategic choice. If you're in the $500K to $1.5M range, you're effectively deciding whether you're building an owner-operated business (optimize for SDE) or a managed business (optimize for EBITDA). That choice determines what you do with your time for the next 12 to 24 months, and it directly drives what your business will be worth at sale.
How to Choose Your Metric
The decision tree is simple:
- Can the business run without you? If no, use SDE. If yes, EBITDA is in play.
- Do you have professional management? If yes, EBITDA. If you are the management, SDE.
- Under $1M revenue? Likely SDE.
- Over $1M and professionally run? Likely EBITDA.
- In the transition zone? Talk to your CPA or a valuation specialist about which better represents your business to buyers.
- Document your choice and methodology before you start marketing.
One last thing: lender requirements will sometimes force the choice. SBA loans are SDE-only. Community banks typically use SDE up to $1M and shift to EBITDA above that. Commercial lenders on larger deals want EBITDA. If you know which lender pool your buyer is likely to come from, you already know which metric will drive the deal.
Torch calculates both SDE and EBITDA from your actual financials, flags which one applies to your business, and helps you present the right number to the right buyer.