Understanding Seller’s Discretionary Earnings
SDE versus EBITDA
When it comes to valuing small businesses, seller’s discretionary earnings, or SDE, is often the most common method. SDE represents the total profits that a business generates, including the owner’s benefits. This number differs from what is shown on the raw financial statement, and when calculating SDE, adjustments are made to show a more accurate representation to the potential buyers of the total profit.
You can also read what are adjustments to income in a business valuation.
Recast Business Profits
You will also hear the term recast profits when dealing with seller’s add-backs and adjustments to income or discretionary spending. Taking the owner’s addbacks and deductions into account, these are all ways to give you normalized earnings before interest taxes, depreciation, and amortization or EBITDA.
Small businesses often have many financial aspects that are unique to themselves, making traditional financial measurements that are often used for larger businesses, like EBITDA, limiting in representing the true value of a small business’s profitability. SDE serves to tailor specifically to small businesses, allowing their cash flow and profitability to be presented in the most accurate way for potential buyers.
Understand what a business valuation is and how SDE is used to give you a normalized EBITDA.
Why Use SDE?
When selling your business, you want your potential buyer to see a full picture of your profits without distractions like the owner’s salary, owner’s benefits, family members’ benefits, discretionary costs, and non-recurring expenses.
Seller’s Discretionary Earnings is what allows this full picture to be painted, considering the types of adds and deductions, giving you the best chances possible in selling your business at your ideal price.
Small businesses commonly have a higher level of owner involvement, resulting in expenses that are often owner-specific. SDEs are especially helpful in this context, as they will show the business’ financials without the owner-specific costs, allowing the buyer to have a full picture of the potential earnings after the EBITDA adjusts.
The income statement and the tax returns should also be tied together as a check and balance to give the recast meaning in the eyes of potential buyers and their lenders.
Read our article on the different business valuation methods.
How is SDE Calculated?
Below is an overview of the steps in how SDE is calculated.
- Calculate net income
Net income is calculated by taking the business’s total revenue and subtracting all of the expenses, including costs of goods, operating expenses, and more.
- Add the owner’s salary
First, the owner’s salary is added back to the net income, as the amount a new owner decides to pay themselves can vary greatly for the new owners. However, what the market says the salary is for the replacement cost of the owner(s) should be deducted. The SDE includes the net owner(s) salaries to show the business what an absentee owner could enjoy with the proper salaries and management in place at local market rates.
- Add any non-cash costs
Non-cash costs, including depreciation and amortization expenses, are then added back to the net income.
Also, learn about what a multiple is in a business valuation.
- Add interest and taxes
Interest and taxes are included as non-relevant expenses and will be added back to the net income.
- Add non-recurring and discretionary costs
Any non-recurring costs, such as remodeling or legal fees, and any discretionary costs considered personal expenses, will be added back to the net income as well.
- Subtract non-discretionary costs
After every factor on the list has been added back, non-discretionary expenses that are essential to running the business, like rent or utilities, are subtracted from the current total to reach the final SDE number.
Learn more about what counts as an add-back with understanding add-backs when selling a business.
What Are Discretionary and Non-Recurring Expense Items?
- Discretionary items
Discretionary items are costs that were paid with business profits but in reality, only benefit the owner and not the business itself. Discretionary expenses often come about when the owner wants the tax benefits of paying through the business.
Examples of common discretionary expenses include life or medical insurance, personal transportation, and personal travel. Ultimately, discretionary expenses include any expenses that benefit the owners, do not benefit the business, and are paid for by the business.
Because discretionary items do not benefit the business, it is useful to add these costs back during SDE, as potential buyers will likely not face these same costs – or at least have the choice in how to spend or not spend their own discretionary items. The previous owner’s discretionary items are rarely relevant to potential buyers.
Also, read our article on navigating unsolicited offers to buy your business.
- Non-recurring items
Non-recurring items are expenses that are relevant to the business yet have only occurred once and are very unlikely to occur again, and so therefore do not represent core business expenses.
Examples of these types of expenses can include expenses like remodeling or legal fees and professional fees like business valuations and business broker fees. Because these costs are unique and improbable for the new owner, it is useful to add these values back while calculating SDE.
Also, understand what my business is worth after all the EBITDA adjustments have been made.
What’s the Difference Between SDE and EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, also known as operating profit, is another value often used to accurately describe the true profit potential of a business. However, there are a few key differences between SDE and EBITDA.
The main difference between SDE and EBITDA is that SDE includes the owner’s pay when calculating add-backs, whereas EBITDA does not. This is helpful for small businesses where owner involvement is often higher. SDE is most commonly used for small to mid-sized companies, whereas EBITDA is most commonly used for businesses of a larger size.
Read about the rule of thumb value in business valuation.
Learn The Benefits of SDE
- Determining the fair market value
SDE will help in determining the fair market value for a business, creating the opportunity for discussions on the sale price. Because of this, SDE can prove to be an efficient negotiation tool.
- Comparability to Other Businesses
SDE is simple and uncomplicated to calculate, and so potential buyers are able to quickly compare two businesses against each other. SDE creates a simple, one-to-one comparison, no matter the industry of the businesses at hand.
- Eliminates un-impactful variables
An SDE value will eliminate variables that are unlikely to impact the potential buyer, including variables like interest, taxes, and non-cash expenses. This will allow the buyer to calculate their own estimates as their expenses will likely differ with the previous owner.
- Risk assessment
SDE can often demonstrate the risk that comes with the business at hand, as a higher SDE will demonstrate strong financials and lower risk. The ability to show lower risk is invaluable in attracting potential buyers.
- Used commonly
The use of SDE is very common with every party involved with small businesses, and so most parties you will work with will be familiar and comfortable with the concept.
Also, read our short guide on choosing a business valuation company.
The Potential Downsides of SDE
- Inconsistent SDE definitions
SDE does not come with a standard definition, and so it is often calculated differently between valuation professionals.
- Ignores tax impact
SDE ignores the impact of income taxes, and potential buyers may want to consider how taxes impact the overall profitability, as there are few cases where taxes are not relevant.
- Can create potential disputes
When working with SDE, there is always a chance that there may be disagreements on what can be added back and what is considered an actual discretionary or non-recurring cost, leading to potential disputes. Solid proof of all add-backs and EBITDA adjustments are critical to the process.
However, when working with business valuation experts like Business Appraisal FL|GA|HI, your SDE will be calculated with the utmost precision and care, reducing any potential risk of disputes.
Why Work with Business Appraisal FL|GA|HI for Your Business Valuation, including SDE?
You want your SDE, the true value of your small business, to most accurately represent the potential profitability of your business. Business valuations are a dynamic and involved process that will assess the true value of companies, and you want the best – and the experienced and efficient valuators of Business Appraisal Florida are ready to help you.
With over twenty years of experience evaluating small businesses like yours, our accredited valuation analysts (AVA) are credentialed to perform business valuations that conform to the Internal Revenue Service (IRS), American Institute of Certified Public Accountants (AICPA), and the National Association of Certified Valuation Analysts (NACVA) professional standards.
Are you ready for your accurate, expert, and effective business valuation? Reach out to our valuation team today for your free consultation.
As a business owner, do you need help with your business valuation steps, or what makes up a certified business valuation? Please call or contact BA FL|GA|HI.