Lesson 2: Understanding Revenue vs. SDE (In Plain English)
Introduction
One of the most common mistakes first-time buyers make is confusing revenue with income.
A business may generate $1,500,000 in revenue.
That does not mean the owner earns $1,500,000.
In small business acquisitions, what matters most is not revenue — it is cash flow.
More specifically:
Seller’s Discretionary Earnings (SDE).
Let’s break this down clearly.
1. What Is Revenue?
Revenue is the total amount of money the business collects before expenses.
If an HVAC company installs systems and services homes, revenue is the total money customers pay.
Revenue does NOT account for:
• Payroll
• Rent
• Equipment
• Insurance
• Fuel
• Taxes
• Marketing
• Debt
Revenue shows business size.
It does not show profitability.
2. What Is SDE?
Seller’s Discretionary Earnings (SDE) represents the total financial benefit available to a single owner-operator.
It includes:
Net Profit
- Owner salary
- Owner perks
- Non-recurring expenses
- Interest
- Depreciation
- Amortization
SDE shows:
What a new owner could realistically earn before debt payments.
3. Why Small Businesses Use SDE Instead of EBITDA
Large companies use EBITDA.
Small owner-operated businesses use SDE.
Why?
Because in small service businesses, the owner often:
• Pays themselves through payroll
• Runs personal expenses through the business
• Adjusts compensation for tax strategy
SDE normalizes those adjustments.
It reflects economic reality.
4. Example Breakdown
Revenue: $1,250,000
Expenses:
• Payroll: $500,000
• Rent: $120,000
• Materials: $250,000
• Insurance: $40,000
• Marketing: $60,000
• Miscellaneous: $80,000
Net Profit: $200,000
Owner Salary: $120,000
Owner Vehicle Expense: $20,000
One-time Legal Expense: $15,000
SDE =
$200,000
- $120,000
- $20,000
- $15,000
Total SDE: $355,000
That is the number buyers evaluate.
5. Why This Matters When Buying
If the asking price is $900,000 and SDE is $355,000:
The business may look expensive based on revenue.
But it may be reasonable based on cash flow.
Valuations for service businesses often fall between:
2.5x – 3.5x SDE
Revenue alone tells you almost nothing about deal quality.
6. The Beginner Mistake
New buyers often say:
“It’s a $2M revenue company!”
Instead, ask:
“How much clean SDE does it generate?”
Cash flow determines:
• Debt coverage
• Personal income
• Risk level
• Valuation
Final Thought
Revenue impresses.
Cash flow sustains.
If you understand SDE, you understand the foundation of small business acquisition analysis.
See SDE Applied in Real Analysis
Review how Seller’s Discretionary Earnings (SDE) impacts valuation and debt coverage in these breakdowns:
• Residential HVAC Company – Structured Deal Breakdown
• Commercial Cleaning Company – Structured Deal Breakdown
• Plumbing Service Company – Structured Deal Breakdown