Seller’s discretionary earnings (SDE) is used in most business valuations, especially for market-based valuations. It is vital to understand your SDE as it shows the worth of your company (or your ownership share within a company). In particular, SDE is essential for owners planning their exit strategy. This guide discusses what the seller’s discretionary earnings are and how you can calculate your SDE with the use of add-backs.
Seller’s Discretionary Earnings (SDE) Explained
Seller’s discretionary earnings, also called SDE, is a way for owner-operator businesses to measure cash flow. This metric includes your profit before subtracting the costs associated with interest, taxes, depreciation, and amortization. SDE also does not subtract your owner’s compensation, most discretionary expenses, or one-time expenses.
SDE is valuable as it provides insights into your company’s earnings before you take a personal profit via salary and other forms of personal compensation and expenditures. Prospective buyers need to understand your discretionary earnings before making an offer for your company as it provides an idea of the current and potential profitability of the organization.
How Do I Calculate My Seller’s Discretionary Earnings (SDE)?
The financial jargon may seem intimidating when you calculate your SDE. However, in practice, it is simple so long as you keep a detailed record of your finances. In simplest terms, you can calculate your seller’s discretionary earnings with the formula below:
- SDE = EBITDA + Owner’s Compensation (and other add-backs)
However, this is a slight oversimplification as the add-backs go beyond the owner’s reported compensation. For example, a non-recurring expense (i.e. costs related to a recent lawsuit) is also added back into the SDE.
Step 1: Calculate Your EBITDA
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a common financial metrics that business brokers use to help determine the value of a company. As mentioned, your EBITDA calculation is also the first step to determining your seller’s discretionary earnings. The equation is simple; as the name implies, your EBITDA includes all of your earnings before subtracting the interest, tax payments, depreciation, and amortization. In other words, your EBITDA can be calculated with this formula:
- EBITDA = net income + interest + taxes + depreciation + amortization
EBITDA does not add back your annual salary as owner, most discretionary expenses, or one-time expenses. It is also not the same as cash flow.
Step 2: Identify Your Add Backs
Add-backs are expenses or benefits that are specific to the business owner. In other words, these expenses go with the owner when they leave the company (see specific types of add-backs below).
Step 3: Determine Your SDE
Once you determine your EBITDA and all relevant add-backs, you will add them together. The amount you arrive at is your seller’s discretionary earnings and is one of the key metrics you will use to determine your overall business value.
What Are The Different Types of Add Backs?
There are four primary types of add-backs you should consider when calculating your discretionary earnings (SDE) — standard expenses, discretionary expenses, one-time expenses, and accounting adjustments. It is also important to note that owner draws are not included in the SDE because they are a part of the balance sheet and not a part of the profit and loss (P&L) statements.
Your standard expenses are the most common add-backs you will make as the owner of your company. This starts with the expenses removed from your profit when you calculate your EBITDA, such as interest, taxes, depreciation, and amortization. However, your salary as the owner is the most notable standard expense you will add back when calculating SDE from your EBITDA figure.
Discretionary expenses are costs that are not directly associated with business operations and are subsequently considered non-essential. They are usually not expected to continue once the buyer takes over the company. For example, this may include personal travel expenses, family costs (i.e. cell phone plans, fuel costs, etc.), personal health insurance, and charitable donations.
One-time expenses, also called non-recurring expenses, are costs that are not expected to happen again in the future. Therefore, they are added back to the seller’s discretionary earnings because the new owner will not have to bear these costs. For example, one-time expenses may include legal fees related to a past lawsuit, equipment repair and upgrade costs, and payment for the design of your website.
In some cases, accounting adjustments occur to provide a more accurate SDE figure. This may include inventory adjustments, non-operating income adjustments, or adjustments to account for receiving a loan (i.e. PPP loan). For example, if you sold a piece of equipment, this might be adjusted to provide a more accurate depiction of the company’s earnings.
Seller’s Discretionary Earnings vs. EBITDA: What is The Difference?
EBITDA does not add back your owner’s compensation, discretionary expenses, or one-time expenses. Consequently, your SDE is always a higher number than your EBITDA. Notably, EBITDA is most commonly used to determine the value of large businesses (i.e. $5 million plus in earnings). SDE is used more for small to midsize businesses. This is because the owners of large businesses usually take on more of an investor role, whereas the owners of small businesses are usually more of a manager and operator that oversees day-to-day operations.
Why Would a Buyer Use SDE Instead of EBITDA?
So, why is SDE used instead of EBITDA? It is used because it adds back the owner’s compensation. This gives a clear understanding of the expected and potential earnings for buyers. To provide a better understanding of why SDE is an excellent metric, let’s review the example below:
- Business A’s EBITDA is $500,000, but the owner takes $150,000 per year.
- Business B’s EBITDA is $500,000, but the owner takes only $50,000 per year.
In this case, the SDE for Business A is $650,000, whereas the SDE for business B is $550,000, a significant difference despite having the same EBITDA. From the buyer’s perspective, the owner’s compensation is not as relevant as the salaries of business owners vary. Therefore, SDE is a way to help eliminate variance and provides a more precise idea of how profitable a company is and can be moving forward.
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Here at Sigma Mergers and Acquisitions, we understand the importance of properly calculating your seller’s discretionary earnings when determining the value of your business in preparation for your exit strategy. However, we understand that there are additional factors that impact value, and we work hard to ensure your business is properly valued to maximize your sale price. To learn more and get started with a free business valuation, schedule a consultation today.