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. The raw financial statement shows a different number from this, and when calculating SDE, we make adjustments to present a more accurate representation of the total profit to potential buyers.
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.
Traditional financial measurements, such as EBITDA, often limit the representation of the true value of a small business’s profitability for potential buyers. SDE tailors specifically to small businesses, presenting their cash flow and profitability in the most accurate way.
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 paint the full picture, considering the types of adds and deductions, and give you the best chances possible to sell 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.
Tying the income statement and the tax returns together as a check and balance gives 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
To calculate net income, you subtract all of the expenses, including costs of goods, operating expenses, and more, from the business’s total revenue.
- Add the owner’s salary
First, add back the owner’s salary to the net income, as the amount a new owner decides to pay themselves can vary greatly. However, deduct the replacement cost of the owner(s) as determined by the market. The SDE includes the net owner(s) salaries to demonstrate what an absentee owner could enjoy with the proper salaries and management in place at local market rates.
- Add any non-cash costs
The company adds back non-cash costs, including depreciation and amortization expenses, to the net income.
Also, learn about what a multiple is in a business valuation.
- Add interest and taxes
Non-relevant expenses include interest and taxes, which 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 adding back all the factors on the list, essential non-discretionary expenses such as rent or utilities are subtracted from the current total to obtain 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 expenses are costs paid for using business profits that benefit only the owner and not the business itself. They occur when the owner wants to take advantage of tax benefits by paying through the business.
Examples of common discretionary expenses include personal insurance (life or medical), personal transportation, and personal travel. Discretionary expenses are business expenses that solely benefit the owners and are paid for by the business.
To calculate SDE (Seller’s Discretionary Earnings), it is advisable to include discretionary expenses in the calculation. Potential buyers may not have the same expenses or may choose not to spend on discretionary items. The discretionary items of the previous owner are usually not important 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 but have only occurred once and are unlikely to occur again. They do not represent core business expenses.
Examples of these expenses include remodeling or legal fees, as well as professional fees like business valuations and business broker fees. Since these costs are unique and unlikely for the new owner, it is important to include them when 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?
BITDA, also known as operating profit, represents earnings before interest, taxes, depreciation, and amortization. Businesses commonly use it to accurately describe the true profit potential. 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 in add-back calculations, while EBITDA does not. This is useful for small businesses with higher owner involvement.
Small to mid-sized companies commonly use SDE, while larger businesses commonly use EBITDA.
Read about the rule of thumb value in business valuation.
Learn The Benefits of SDE
- Determining the fair market value
SDE determines fair market value for a business and facilitates discussions on the sale price. It is an efficient negotiation tool.
- Comparability to Other Businesses
SDE is easy to calculate, allowing potential buyers to quickly compare two businesses. It provides a simple, one-to-one comparison regardless of the industry.
- Eliminates un-impactful variables
An SDE value eliminates irrelevant variables such as interest, taxes, and non-cash expenses. This allows the buyer to calculate their own estimates, considering that their expenses may differ from the previous owner.
- Risk assessment
A higher SDE indicates strong financials and lower risk, which is valuable in attracting potential buyers.
- Used commonly
The use of SDE is common in small businesses, and most parties you work with will be familiar and comfortable with it.
Also, read our short guide on choosing a business valuation company.
The Potential Downsides of SDE
- Inconsistent SDE definitions
Valuation professionals often calculate SDE differently because it does not come with a standard definition.
- Ignores tax impact
SDE disregards income taxes, and buyers should consider the impact of taxes on profitability, as taxes are generally relevant.
- Can create potential disputes
When working with SDE, disputes may arise regarding add-backs and EBITDA adjustments. It is crucial to have solid proof for all such adjustments.
When you work with business valuation experts like Business Appraisal FL|GA|HI, they calculate your SDE 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?
To accurately represent the potential profitability of your small business, you need a reliable SDE. Business valuations by experienced and efficient valuators from Business Appraisal Florida can help assess the true value of companies. Visit this link to learn more.
With 20+ years of experience, our accredited valuation analysts (AVA) can perform business valuations that meet professional standards set by the IRS, AICPA, and NACVA.
Are you ready for your accurate, expert, and effective business valuation? Reach out to our valuation team today for your free consultation.
If you need help with your business valuation or a certified business valuation, please contact BA FL|GA|HI.