What is Seller’s Discretionary Earnings (SDE)?

What is Seller’s Discretionary Earnings (SDE)?

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.

Standard Expenses

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

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

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.

Accounting Adjustments

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.

Receive a Free, No-Obligation Business Valuation With Sigma Mergers and Acquisitions

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.

 

How Much Money Does a Business Owner Really Make?

One of the most difficult aspects of acquiring a business is understanding how much money a business owner is truly making. If the 5.6 million-word tax code doesn’t make it difficult enough, business owners and their accountants sometimes add to the confusion with their creative bookkeeping techniques.

You’ve probably heard a dozen terms that describe the profit of a business – Cash Flow, True Owner Net, Seller’s Discretionary Earnings (SDE), Seller’s Discretionary Cash Flow, Owner Benefit, Adjusted EBITDA. These terms essentially all answer the same question – how much money does the owner really make?

What you have to understand and accept first, before even looking at a financial statement or report, is that the objective of a business owner is to make as much money and pay as little tax as possible, and that accountants and CPAs find ways to help business owners accomplish this goal. This can make your attempt to determine true cash flow a little more difficult, but always keep one thing in mind – business owners have to prove what they claim.

Recasting

The first step taken in determining a business’ cash flow is to recast the financials. Recasting financials is a fancy term that simply means correcting, normalizing or adjusting them, to provide a more accurate picture of what the business is truly producing in regards to profit. When financials are recasted, the goal is to find expenses to add back into the net profit of the business – we call these items add-backs or adjustments.

EBITDA

Start with EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. This simply refers to a business’ profit before any interest, certain taxes, depreciation and amortization are deducted as expenses. Depreciation and amortization are non-cash expenses, meaning they are booked as expenses and come off the bottom line, but there isn’t actually any expense being paid out by the company in real cash. As for interest and certain taxes, they are added back because the new owner will not be incurring these same expenses.

Owner’s Salary and Benefits

Don’t forget about the owner’s salary, or any payouts to partners or other family members that are shown as expenses. These items are added back too. This also goes for other legitimate business expenses that benefit the owner, such as health insurance, life insurance, 401(k) matching or other employment costs. Keep in mind, while these salaries and benefits are legitimate adjustments, there may also need to be a counter-adjustment to cover any replacement salaries for positions needing to be filled after certain roles are vacated by exiting family.

Fringe Benefits and Other Personal Expenses

As a rule-of-thumb, anything that is a personal expense is an add-back. It’s typical for owners to run some expenses through the business that are actually more personal in nature than business. This commonly can include items such as meals, entertainment, travel, family cell phone plans and personal vehicles, for example. Keep in mind that some of these items could be a combination of both personal and business expenses, so only and add back the portion of the expense that is truly for personal use.

Discretionary Spending

In addition to personal expenses, there’s also discretionary spending to account for. These expenses can include charitable donations, excessive legal fees or season tickets to a local sporting venue – specific items that are categorized as legitimate business expenses, but are not mandatory to operate the company successfully. Hence, discretionary, meaning a new owner can choose not to spend this money and the business will not suffer.

Non-Recurring Expenses

Another major add-back can be the one-time, non-recurring or extraordinary expenses. Maybe a business owner paid cash for a new piece of equipment instead of capitalizing it, maybe there was a major repair that had to be done to the building after a storm, or maybe the business relocated and incurred moving expenses. These are examples of legitimate business expenses that were unique and only appear once in several years of financial records. Those items are added back in because they skew the normal cash flow picture of the business.

Once the financial statements have been examined and all of these different types of adjustments have been identified and added back, the recasting is complete. Now there is a very clear understanding of what the business’ true cash flow is. Think of it as a pot of money at the end of the recasting rainbow – then it’s up the new owner of the business to determine how they want to run the books, and allocate those funds as they see fit.

 

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Scot Cockroft Business Broker
Hi, I’m Scot Cockroft.

When I founded Sigma Mergers and Acquisitions back in 2003, I had sold my business the year prior.

Now, that can sound good, but let me tell you, back in 2003, it was not easy to sell a business. Not that I’m saying in modern day times it’s easy to sell a business, but back then I interviewed broker after broker after broker, and no one was interested in actually seeing the value that my business brought to the table.

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Sigma is a the leading business broker in with Corporate offices in Dallas/Fort Worth with roots from 1984. Over 600 businesses sold in Dallas, Fort Worth, Texas, Oklahoma and across the South. Sigma provides full business brokerage services with NO upfront fees. We provide Market approach business valuations for business sales. Sigma is passionate about helping business owners achieve their goal of financial security. Contact us today for a free no obligation business valuation. We are here to help you achieve your goals.

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