As a small or medium business owner, you want to ensure that your business sells for the highest possible price. On the other hand, potential buyers aim to pay the lowest price. So, how can you bridge this gap? One effective way is by presenting buyers with an estimate of the cash they can expect to generate from the business - this is where Seller's Discretionary Earnings (SDE) comes into play, and why it is vital during exit planning. In this blog post, we will provide an overview of SDE, its impact on business value, and how to calculate it. If you're considering exit planning, SitePlan's Mergers and Acquisitions services can guide you through the process and maximize your business value.
What Is Seller's Discretionary Earnings?
Seller’s Discretionary Earnings (SDE) is a metric used by owner-operated businesses to measure the full financial benefit the business generates for its owner. It calculates the net profit of the company and adds back certain bottom-line expenses, such as owner's compensation, business travel, health insurance, one-time expenses, interest, amortization, and depreciation. SDE focuses on necessary business expenses and excludes discretionary or personal expenses specific to the seller.
. These expenses can include:
- Owner's compensation
- Business travel expenses
- Health insurance
- One-time expenses (such as equipment upgrades)
- Interest
- Amortization and depreciation
How SDE Impacts Business Value
Preparing an SDE is crucial when valuing a small business. The sale price of any business is often determined by comparing its financial performance to recently sold businesses in the same industry and market. Cash flow is usually the most important metric in this valuation, with SDE being the preferred measure of cash flow for owner-operated businesses. The higher the value of the cash flow used in the calculation, the higher the potential sale price. Adjustments to the SDE calculation can have a significant impact on the final valuation..
For instance, let's consider Janet, the owner of Janet's Auto Spa. If Janet pays herself $100,000 annually and incurs additional expenses like an annual auto spa owners conference in Hawaii ($6,000) and a holiday party for clients ($4,000), reviewing the P&L statement alone would show a net income of $200,000. However, when considering SDE and adding back the discretionary expenses, the income would amount to $310,000.
If businesses in the auto spa industry typically sell for a multiple of two times cash flow, the value of Janet's Auto Spa would be $620,000. Adjustments to the SDE calculation can significantly impact the valuation since it is a multiplier.
When Is EBITDA Used?
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is another valuation metric that excludes certain expenses. However, unlike SDE, EBITDA does not exclude the owner's compensation. Businesses with earnings over one or two million dollars often use EBITDA as an evaluation metric because buyers expect professional managers to run the operation. SDE is generally higher than EBITDA, but the multiples applied to SDE calculations are typically lower when compared to adjusted EBITDA.
All else being equal, SDE tends to be higher than EBITDA, but the multiples applied to SDE calculations are typically lower than those used for adjusted EBITDA.
How to Calculate SDE
To calculate SDE, start with the net profit generated by the business before taxes and add back discretionary expenses. This process is known as recasting. Expenses that can be recasted include:
- Owner's salary (including perks like health insurance, automobiles, and fuel)
- Expenses that aren't necessary for running the business (such as trade show costs, other travel expenses, and charitable contributions)
- One-time expenses that are unlikely to recur (e.g., website upgrades)
- Interest on loans carried by the owner
- Taxes like payroll taxes paid by the company on the owner's salary
- Depreciation and amortization
The sum of direct business operating expenses (e.g., rent and utilities) and the discretionary add-backs equals the SDE.
For example, consider Bryan's Pet Supply. If the business generated $800,000 in gross revenues in the most recent year, the add-backs could include the owner's salary ($100,000), personal phone and internet expenses ($500), the cost of attending a trade show ($6,000), IT services to repair a computer system ($400), and a one-time cost to replace damaged outdoor signage ($400).
The Role of Add-Backs in SDE
While using add-backs to prepare an SDE statement is generally accepted, what counts as an add-back can be disputed. Prospective buyers may argue that certain expenses, like business travel, are necessary regardless of the owner.
In general, add-backs should meet several criteria:
- Benefit the owner, not the business or its employees
- Be paid for by the business
- Appear as expenses on tax returns and income statements
Standard add-backs such as the owner's salary and depreciation on business property are typically straightforward and rarely disputed. Discretionary items like health insurance, retirement account contributions, health club dues, and charitable contributions are also likely to be agreed upon as long as they appear on tax returns as deductions.
However, non-recurring and non-essential items may be subject to dispute. It is crucial to have a qualified CPA or a SitePlan Client Partner to prepare these financial statements to ensure both legal and financial compliance.
Understanding Seller's Discretionary Earnings and its impact on business value is crucial for small and medium business owners considering exit planning. By calculating the SDE, you can establish a fair sale price for your business and justify its value to potential buyers. To ensure accurate financial statements and maximize your business value, it is recommended to work with a qualified CPA or a SitePlan Client Partner.
At SitePlan's Mergers and Acquisitions, we specialize in guiding businesses through the exit planning process. Contact us today to discuss your M&A needs and maximize the value of your business.
