As a business owner, you’ve likely heard of seller’s discretionary earnings (SDE). But do you know what it is, how it’s calculated, and how it can impact the value of your business?
In this post, we’ll explore SDE in-depth, and provide insights that will help you understand how to use it to your advantage when selling your business.
Let’s get started.
What is seller’s discretionary earnings?
Seller’s discretionary earnings (SDE) is a critical metric for business owners who are planning to sell their business.
SDE, also known as seller’s discretionary cash flow, is the pre-tax earnings of a business that are available to the owner, including salaries, perks, and non-recurring business expenses that are unlikely to continue after the business is sold.
In short, SDE represents the total financial benefit the owner of the business can reasonably expect to receive from the business each year.
Once you’ve calculated the SDE amount, you can use it as part of a business valuation process and determine what it could be worth in a sale.
How do you determine seller’s discretionary earnings?
To determine SDE, you need to start with the business’s net income and then add back any owner-specific expenses that are not necessary for the operation of the business.
To determine SDE, start with your business’s net income, and then add back any expenses that are specific to you as the owner. This might include things like your salary, bonuses, health insurance, car payments, and other personal expense that the new owner may not incur.
You should also add back any one-time expenses, such as legal or accounting fees associated with the sale of the business.
What could qualify as discretionary expenses?
When determining SDE, it’s important to understand which expenses can be considered discretionary and which are non-discretionary.
As I mentioned earlier, discretionary expenses are those that are specific to the owner and are not necessary for the operation of the business.
Some examples of owner-specific expenses that could qualify as discretionary expenses:
- Owner’s salary and benefits
- Personal expenses paid through the business (e.g., car, travel, personal meals – think things that result in a personal benefit)
- Depreciation and amortization expenses (non cash expenses)
- Interest expense and taxes paid by the business that are not necessary for the operation of the business
It’s important to call out that not all owner-specific expenses are necessarily discretionary. For example, if the owner of a consulting business is also the primary consultant, their salary and benefits would not be considered discretionary, as they are necessary for the operation of the business.
On the other hand, if the owner of a retail business takes a salary that is higher than what would be paid to an outside manager, the excess amount could be considered a discretionary expense.
It’s also worth noting that one-time expenses, such as the cost of relocating the business or a major marketing campaign, could also be considered discretionary expenses, as they are non recurring expenses necessary for the operation of the business.
Is SDE the same as profit?
SDE is not the same as profit, although the two terms are often used interchangeably. Profit is the amount of money that a business makes after all expenses, including taxes, have been paid. It’s a broader measure of a business’s financial performance and does not take into account the owner’s personal or other discretionary spending.
SDE, on the other hand, is the amount of money available to the owner of the business after all expenses have been paid.
While profit is certainly an important metric to consider when valuing a business, SDE is often a more accurate reflection of the true earnings potential of the business. By adding back owner-specific expenses and one-time expenses, SDE provides a clearer picture of how much money the new owner can expect to make from the business.
Sellers discretionary earnings vs net income
It’s important to note that SDE is not the same as net income on financial statements. While net income is a useful metric for understanding the overall profitability of a business, it doesn’t provide a complete picture of the earnings potential of the business.
SDE, on the other hand, takes into account owner-specific expenses and one-time expenses, which provides a more accurate reflection of the true earnings potential of the business. For this reason, SDE is often used as the basis for valuing a business.
How is SDE calculated?
As mentioned above, SDE is calculated by starting with the business’s net income and then adding back owner-specific expenses that are not necessary for the operation of the business.
Here’s a step-by-step breakdown of how to calculate SDE:
- Start with the business’s net income: Begin by calculating the business’s net income for the year. This is the revenue the business earned minus all of its expenses, such as salaries, rent, taxes, and other costs.
- Add back any owner’s salary or compensation: If the owner of the business takes a salary or other compensation, add it back to the net income. This adjusted cash flow amount is often called “owner’s salary” or “owner’s compensation.”
- Add back any personal expenses: If business paid for personal items of the owner, such as a car or phone, add these expenses back to the net income.
- Add back any other discretionary expenses: In addition to owner’s salary and personal expenses, there may be other expenses that the owner considers discretionary. These could include travel, entertainment, or other expenses that are not strictly necessary for the operation of the business. Add these expenses back to the net income as well.
- Subtract any non-discretionary expenses: Finally, subtract any non-discretionary expenses that the new owner would have to incur if they were to purchase the business. These expenses could include loan payments, rent, or other fixed costs that the new owner would need to pay.
The result of this calculation is the seller’s discretionary earnings (SDE). This represents the amount of cash flow available to the owner of the business, which can be used to pay for expenses and other obligations.
How do you value a company using SDE?
Valuing a company using SDE is a relatively simple process. First, you’ll determine the SDE for the business. Next, you’ll apply a multiple to that number to arrive at a valuation.
The multiple that you use will depend on a variety of factors, including the industry that the business is in, its growth potential, and the current market conditions.
What is a good SDE multiple?
As mentioned above, the multiple that you use to value your business will depend on a variety of factors.
As a general rule of thumb, businesses in most industries can be valued at between 2 and 4 times their SDE.
If your business has a high growth potential, a loyal customer base, and a strong competitive position in the market, you may be able to command a higher multiple.
On the other hand, if your business is in a declining industry or has limited growth potential, you may need to settle for a lower multiple. It’s also worth noting that larger businesses typically command lower multiples than smaller businesses, due to the reduced risk associated with larger businesses.
Ultimately, the multiple that you use to value your business should reflect a realistic assessment of the company’s future earnings potential, as well as the level of risk associated with owning the business.
Seller discretionary earnings example
To illustrate how SDE works in practice, let’s walk through an example.
John owns a small manufacturing business that has a net income of $200,000 per year. John is a full time owner operator and pays himself a salary of $80,000 per year, and drives a company car that costs $10,000 per year to operate. In addition, John has incurred $20,000 in legal fees associated with the sale of his business.
To calculate the SDE for John’s business, we would start with the net income of $200,000 and add back John’s salary, car expenses, and legal fees. This would give us an SDE of $310,000 ($200,000 + $80,000 + $10,000 + $20,000).
If we assume that John’s business can be valued at 3 times its SDE, then the business would be worth approximately $930,000 ($310,000 x 3).
Switching to professional management
Before we wrap up, I want to cover a strategy that can dramatically increase your valuation and potential exit price.
One way to increase your small business valuation multiple and company value is to swap out the current manager or owner for a professional manager. This has multiple advantages, such as helping your valuation and making your company more marketable. A company that is less reliant on the owner is typically seen as being more valuable, as there is less risk involved.
Professional buyers know that owners tend to leave their businesses after they sell them, rather than sticking around and helping. Ideally the owner’s exit from a business is of little or no consequence for its future cash flow and value…but if it cannot continue growing in value without your help, it’s a real turn-off to buyers.
Hiring professional management can help take some of the responsibility off of your shoulders and put it onto someone who is trained to handle such duties. Additionally, this will give the company a more professional appearance, which can attract investors.
Making the transition from an owner-run business to a management-run business can take time, but it can be transformational if you want to sell your business or attract outside investors.
Just by making this one change you’ll see a drastic increase in the EBITDA multiple you’ll be able to sell your business at:
- Owner Operated: 2.5X
- Professional Management: 4.5X
This means the company is worth 2X more (on average, across all industries according to BVR Deal Stats).
Through transitioning to professional management we can instantly create multiple arbitrage and have more buyers that are willing to pay a higher price.
Conclusion
Understanding seller’s discretionary earnings is essential for any business owner looking to sell their business. By accurately calculating SDE and using it to value your business, you can ensure that you receive a fair price for your hard work and investment.
Remember, the multiple you use to value your business will depend on a variety of factors, so it’s important to seek advice from an M&A advisor or business broker to help you arrive at a realistic valuation.
I hope you found this helpful, feel free to drop a comment if you have any questions.
