A multiple of SDE is not a payback period. The cash that repays the price is what is left after a manager's salary, the equipment and the tax.
Divide the price by the cash the business actually produces for its owner, after a market manager's salary, maintenance capex and tax, not by SDE. A business bought for 1,200,000 at 3.0 times its 400,000 of SDE does not pay back in three years: it generates 222,500 of free cash flow, so the cash payback is 5.39 years, and 11.8 years once the cash is discounted at a 15 per cent required return.
Worked in full in Buying a Small Business by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A buyer looks at a fictional business listed at 3.0 times seller's discretionary earnings. The buyer will hire a general manager rather than work in the business, or will pay themselves a market salary for doing so, which is the same thing. The deal is an asset purchase, so the price is amortised for tax. All inputs are illustrative and the cash flow is held flat, with no growth.
| Input | Value |
|---|---|
| Purchase price | 1,200,000 |
| Seller's discretionary earnings (SDE) | 400,000 |
| Market salary for a general manager, loaded | 90,000 |
| Maintenance capex a year | 30,000 |
| Tax rate on business income (illustrative) | 25% |
| Tax amortisation of the price, mostly goodwill | 15 years |
| Buyer's required return | 15% |
EBITDA = SDE − market manager salary = 400,000 − 90,000 = 310,000
Taxable income = 310,000 − 1,200,000 / 15 of amortisation = 310,000 − 80,000 = 230,000
Tax = 230,000 × 25% = 57,500
Free cash flow = 310,000 − 30,000 capex − 57,500 tax = 222,500
SDE is a pre-salary, pre-capex, pre-tax figure built to compare businesses whose owners pay themselves differently. It is not cash available to repay a purchase price. The full bridge from a broker's SDE to EBITDA, add-back by add-back, is in how to convert SDE to EBITDA.
Payback = price / annual free cash flow = 1,200,000 / 222,500 = 5.39 years
On EBITDA it would be 3.87 years; on SDE, 3.0.
Excel: =Price/FCF, or with uneven cash flows, the first year in which =SUM($B$2:B2) reaches the price
Simple payback treats a dollar in year 5 like a dollar today. A buyer who could earn 15 per cent elsewhere for the same risk should count each year's cash at its present value and ask when the cumulative present value reaches the price. With a level cash flow there is a closed form:
Discounted payback = −ln(1 − price × r / FCF) / ln(1 + r)
price × r / FCF = 1,200,000 × 15% / 222,500 = 0.8090
= −ln(1 − 0.8090) / ln(1.15) = 11.8 years
Excel: =NPER(15%,222500,-1200000)
| Year | Free cash flow | Discount factor | Cumulative cash | Cumulative present value |
|---|---|---|---|---|
| 1 | 222,500 | 0.8696 | 222,500 | 193,478 |
| 3 | 222,500 | 0.6575 | 667,500 | 508,018 |
| 5 | 222,500 | 0.4972 | 1,112,500 | 745,855 |
| 6 | 222,500 | 0.4323 | 1,335,000 | 842,047 |
| 10 | 222,500 | 0.2472 | 2,225,000 | 1,116,676 |
| 12 | 222,500 | 0.1869 | 2,670,000 | 1,206,088 |
Cumulative cash passes the 1,200,000 price during year 6; cumulative present value only passes it during year 12. The gap is the time value of money on a long payback, and it is why the free cash flow yield, 18.5 per cent here, is the quicker test: if it is below the required return, the purchase never pays back in present value terms, however long the buyer waits.
| Multiple of SDE | Price | Free cash flow | Simple | At 12% | At 15% | At 20% |
|---|---|---|---|---|---|---|
| 2.5x | 1,000,000 | 219,167 | 4.56 | 7.0 | 8.3 | 13.4 |
| 3.0x | 1,200,000 | 222,500 | 5.39 | 9.2 | 11.8 | never |
| 3.5x | 1,400,000 | 225,833 | 6.20 | 12.0 | 19.0 | never |
A higher price brings slightly more cash, because more of it is amortised for tax, but nowhere near enough to keep pace. A buyer who wants the discounted payback inside five years at 15 per cent can pay at most 718,980 for this business, 1.80 times SDE. That is not a recommendation to bid there: a business that keeps earning after payback is worth more than its payback suggests, and the perpetuity value of 222,500 at 15 per cent is 1,483,333, somewhat less in practice because the tax amortisation, and the cash it saves, ends after fifteen years. Payback measures how long the buyer's money is at risk, not what the business is worth.
Reading the SDE multiple as a payback period. "Three times earnings, so it pays for itself in three years" counts the owner's own salary as a return on capital, ignores the equipment that wears out and the tax on the profit, and lands at 3.0 years against a true 5.39. If the buyer borrows to fund the deal, the lender is paid before any of the 222,500 reaches the buyer, which is why the levered measure is a cash return on the equity invested, worked in what return on investment buying a small business earns.
The book takes two real-shaped acquisitions through ten years of cash, debt and tax in the free workbooks for this case.
No. SDE is before the owner's salary, capex and tax. In the illustrative case 400,000 of SDE becomes 310,000 of EBITDA after a 90,000 manager's salary and 222,500 of free cash flow after 30,000 of capex and 57,500 of tax, so a 1,200,000 price pays back in 5.39 years, not 3.0.
With level annual cash flows, use NPER: =NPER(15%,222500,-1200000) gives 11.8 years. It solves the number of years at which the present value of the cash flows equals the price. With uneven cash flows, discount each year in a column and find the first year in which the running total reaches the price.
There is no standard, but a useful test is the free cash flow yield against your required return. At 222,500 on 1,200,000 the yield is 18.5 per cent: at a 15 per cent required return the price pays back in 11.8 years in present value terms, and at 20 per cent it never does.
This article is one calculation from Buying a Small Business. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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