When evaluating a business for sale, Seller’s Discretionary Earnings (SDE) often become a focal point. Understanding this financial metric is crucial for both buyers and sellers to accurately assess a business’s profitability and true value. In this guide, we’ll break down what SDE is, how it’s calculated, and why it matters.
Seller’s Discretionary Earnings (SDE) Explained
Seller’s Discretionary Earnings represent the total financial benefit a full-time owner-operator can expect to earn from a business in a single year. It’s widely used in small business valuations, particularly for businesses with revenues under $10 million.
The SDE figure provides a clear picture of profitability by considering earnings before interest, taxes, depreciation, and amortization (EBITDA) while also adding back certain owner-specific expenses that would not transfer to a new buyer. In essence, SDE demonstrates how much money a new owner could potentially take home
Company A
EBITDA is $750,000
Owner-operator’s annual salary is $250,000
SDE is $1 million
Company B
EBITDA is $750,000
Owner-operator’s annual salary is $100,000
SDE is $850,000
In the above example, Company A’s SDE is $1 million. Company B’s SDE is $850,000.
This means that despite having the same EBITDA, the SDE between the two companies is far apart. For this reason, small to mid-sized businesses are often best suited using SDE multiples as opposed to an EBITDA multiple (which is ideal for large companies where the owner takes more of an investor role than an operator).
How Is SDE Calculated?
Calculating SDE involves adjusting the net income by adding back discretionary expenses. These include costs unique to the current owner’s operations or lifestyle. The basic formula is:
SDE = Net Income + Owner’s Salary + Discretionary Expenses + Non-Recurring Expenses + Depreciation + Interest + Taxes
Key Add-Back Categories:
- Owner’s Compensation: The salary or draw taken by the owner is included as this is discretionary.
- Non-Essential Expenses: Items such as personal travel, vehicle expenses, or club memberships paid through the business.
- Non-Recurring Expenses: One-time costs like legal settlements or moving expenses.
- Depreciation and Amortization: Non-cash expenses that reduce reported income but do not impact cash flow.
- Interest and Taxes: These are typically removed to standardize earnings.
Each adjustment ensures the SDE figure reflects the business’s potential profitability under new ownership.
Why Is SDE Important?
SDE is crucial for small business valuations as it provides buyers with a realistic view of how much they can earn after acquiring the business. It also helps sellers demonstrate their business’s profitability more transparently. When used in conjunction with a multiple—a factor based on industry standards, market conditions, and business performance—SDE helps determine the market value of a business.
Common Misconceptions About SDE
- SDE Equals Profit: While SDE indicates profitability, it is not the same as net profit. It accounts for adjustments to present an owner-operator’s potential earnings.
- Higher SDE Always Equals Higher Value: While a higher SDE is attractive, other factors like market trends, competition, and growth potential significantly influence a business’s valuation.
- All Expenses Are Discretionary: Only costs that are truly non-essential and owner-specific qualify as discretionary expenses.
SDE in Business Valuation
Business brokers and appraisers often use SDE as the foundation for small business valuations. Here’s how it fits into the process:
- Determine SDE: Start with accurate bookkeeping and detailed financial records.
- Apply an Industry Multiple: This is typically between 1.5x and 4x for small businesses, depending on the industry, location, and business performance.
- Adjust for Market Conditions: External factors like economic trends or changes in consumer behavior can influence the valuation multiple.
For example, a business with an SDE of $200,000 and an industry multiple of 2.5x would have an estimated value of $500,000.
How to Maximize Your SDE
If you’re preparing to sell your business, maximizing SDE can increase your valuation. Here are some strategies:
- Streamline Operations: Reduce unnecessary expenses and improve efficiency.
- Clean Up Financial Records: Ensure all add-backs are well-documented and justifiable.
- Boost Revenue: Explore opportunities to grow sales and expand your customer base.
SDE vs. EBITDA: What’s the Difference?
While SDE and EBITDA are both metrics for evaluating profitability, they serve different purposes:
- SDE focuses on small businesses and includes owner-specific adjustments.
- EBITDA is more commonly used for larger businesses and does not account for discretionary or non-recurring expenses.
Understanding these differences ensures the correct metric is applied during the valuation process.
How a Business Broker Calculates Your Seller’s Discretionary Earnings (SDE)
Your business broker first determines your pre-tax income.
They will then add back costs associated with interest, depreciation, and amortization. This financial figure is known as your earnings before interest, taxes, depreciation, and amortization (EBITDA).
The business broker then adds back all recurring and non-recurring (one-time) costs to your EBITDA figure (see add-backs below). This produces your SDE, which plays a pivotal role in determining the fair market business value for your company.
Financial Considerations for an SDE Calculation
As mentioned, your business broker will first calculate your pre-tax income. They must also calculate your tax expenditure, owner’s compensation, net interest expense, depreciation deductions, and amortization. These values are derived from your company’s financial documents. During the valuation, you may be asked to provide your:
- Federal tax returns (3+ years)
- Profit and loss (P&L) reports
- Balance sheets
- Customer lists (with the percentage of revenue for each customer)
For example, if you are receiving a business valuation for an appliance service company (or another home improvement or service repair business type), then you will need to provide your percentage of new construction, retrofit, and service. Your business broker may also need your percentage of residential and commercial revenue.
The Different Types of Owner Add-Backs Used for SDE Calculation
The two primary types of owner add-backs used for SDE are recurring and non-recurring add-backs. Recurring add-backs include your standard and discretionary expenses. Discretionary expenses are add-backs that are not expected to continue with the new owner. Below is a breakdown of the primary add-back types.
Recurring Add-Backs
Owner’s compensation is the primary add-back during an SDE calculation. This is the amount that you pay yourself annually as the company’s owner. However, there are additional add-backs. Specifically, SDE adds back all recurring (continual) expenses. Other recurring add-backs include:
- Family member compensation – If other family members are compensated, then their salaries are also added back.
- Family insurance policies – This can include (but is not limited to) auto, property, health, and life insurance.
- Travel, meal, and entertainment expenses – This should be added back if the expense was not entirely business related
- Club expenses (i.e. golf and country club) – Club dues and expenses are discretionary and will not transition to the new owner. Therefore, they should be added back.
- Family phone expenses – Any personal or family phone plans that are not carried over to the buyer are added back.
- Charitable donations – This could also be considered non-recurring, depending on the context.
Non-Recurring Add-Backs
Non-recurring add-backs are (most often) one-time expenses. They are not expected to be necessary expenditures for the new owner. Non-recurring add-backs your business broker may identify include:
- Revenue items – These are expenses with a short-term impact on the business. For example, this may include costs to repair your service trucks.
- PPP loans – This, along with similar government loans, are also included as non-recurring add-backs.
- Sale of asset – If you have purchased any tangible or intangible assets, then these should be added back.
- Expense items – Any one-time expense items are added back. This is separate from recurring business expenses such as rent, utilities, wages, etc.
- Loss on insurance claim (non-reimbursed) – If you filed an insurance claim that was denied, then you should add back the non-reimbursed expenditure
- Major repair, improvement, or purchase – This includes any one-time repair or improvement for business purposes
- Major legal, accounting, or consulting expense – For example, any legal fees associated with prior lawsuits are not expected costs for the buyer
- Major one-time marketing costs (i.e. website design) – Any major costs for marketing that are not ongoing are added back.
Who Needs an SDE Calculation?
Any owner-operator business needs an SDE calculation, particularly business owners who are planning their exit strategy. With that said, SDE is also beneficial for business owners who are not ready to sell as it helps them make better decisions in regard to business growth.
Keep in mind, SDE is recommended for small to mid-sized businesses. Companies with $10 million in more in annual revenue may be better suited for an EBITDA calculation and multiple. Notably, industries and business types that typically require an SDE calculation include:
Contact Brentwood Growth for a
Complimentary Business Assessment
We are an experienced business brokerage that takes pride in helping business owners understand the full value of their company and receive full value during a business sale. We provide free, no-obligation business valuation services, which involve calculating your seller’s discretionary earnings (SDE).
Contact us today for more information and to receive your business valuation and assessment.
