Are you a small business owner thinking about selling? One crucial metric to understand is how to calculate seller’s discretionary earnings (SDE). Many owners feel they may not understand calculating SDE fully and its importance for business valuation.
Seller’s discretionary earnings represents the total financial benefit a business brings to its owner. It’s not just about profit, but about the true discretionary cash flow you, as the owner, pocket. Let’s examine how to calculate seller’s discretionary earnings to help small business owners with business valuation and understanding their company’s true financial performance.
Table Of Contents:
- Understanding Seller’s Discretionary Earnings (SDE)
- How to Calculate Seller’s Discretionary Earnings (SDE)
- Calculate SDE: A Practical Example
- Add-Backs: Common Points of Contention
- Increase Sales to Increase SDE
- Navigating the Sale Process
- Conclusion
Understanding Seller’s Discretionary Earnings (SDE)
Seller’s discretionary earnings (SDE) goes by many names. You might also hear it called adjusted cash flow, total owner’s benefit, or seller’s discretionary cash flow. No matter the name, it all boils down to figuring out the actual financial return for a business owner.
SDE vs. EBITDA: What’s the Difference?
Many get SDE confused with EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA is indeed another common way to measure earnings. SDE and EBITDA both involve adjusting a company’s financial statements.
But, SDE goes a step further by factoring in elements such as the owner’s salary. This is because, unlike EBITDA which is used for valuing larger businesses, SDE is designed to be used for owner-operated companies. So, if you own a smaller business, SDE often paints a clearer picture of the business’s financial reality.
This helps because EBITDA does not consider what any new owner would receive from the business and their potential discretionary expenses, like the business owner’s salary and other financial benefits or one-time transactions. The seller’s discretionary earnings formula may be best to use in this case.
Why Calculate SDE?
Understanding how to calculate SDE is useful for both sellers and buyers. For sellers, a solid SDE can justify your asking price. It highlights the true earning potential to possible buyers, beyond the standard profit and loss statement.
For buyers, SDE offers a clearer view of the cash flow they can expect. SDE can also help them make informed business decisions about the financial benefits of owning the small business. It is therefore one of the most valuable key figures to examine when you are transacting a small business sale or purchase.
How to Calculate Seller’s Discretionary Earnings (SDE)
The goal when you calculate SDE is to “recast” the year-end income statement, making certain adjustments. You start with the net profit and then add back those “discretionary” expenses and other items. The goal is to uncover how much cash flow is actually available to a potential owner.
Here’s a simplified formula for how to calculate seller’s discretionary earnings:
SDE = Net Profit + Owner’s Compensation + Discretionary Expenses + Non-Recurring Expenses + Interest + Depreciation + Amortization
Let’s break down each component and how to find it:
Net Profit
Net profit is your business’s bottom line profit after all expenses and taxes are deducted. This information can typically be found on your income statement or tax return. This number can also be used as a starting point for financial experts to recast earnings and SDE on an annual basis.
Owner’s Compensation
This covers the owner’s salary, wages, and any benefits they receive. Owner’s compensation, cars and fuel, and health insurance, are owner benefits, are definitely things you can add back when doing this process. Be sure that it includes perks such as these when you calculate SDE.
Discretionary Expenses
Discretionary expenses include costs that benefit the owner but aren’t strictly necessary for running the business. Think of these as personal perks paid by the company. To qualify as discretionary, each expense should show as an expense on the tax returns, be paid for by the business, and benefit the owner(s).
Common examples are business travel expenses, social club memberships, health club dues, charitable contributions, retirement account contributions, and contributions or donations that another owner might choose not to incur.
Non-Recurring Expenses
These are one-time or unusual expenses that are unlikely to happen again. Examples include restructuring costs, costs related to acts of nature, emergency repair costs, asset sales, and litigation expenses. Removing these provides a clearer view of ongoing earnings.
Interest, Depreciation, and Amortization
These are non-cash expenses that are added back to reflect the total cash flow available. By looking at business EBITA, the resulting profit will not be affected by taxes, depreciation, or amortization. Interest, depreciation, and amortization expenses can be commonly found on the business’ tax returns.
Calculate SDE: A Practical Example
Let’s say we have “Sarah’s Coffee Shop.” Here’s how we might calculate her SDE:
| Item | Amount |
|---|---|
| Net Profit | $50,000 |
| Owner’s Salary | $70,000 |
| Owner’s Health Insurance | $5,000 |
| One-Time Equipment Upgrade | $3,000 |
| Interest | $1,000 |
| Depreciation | $2,000 |
| Amortization | $500 |
| SDE | $131,500 |
In this case, Sarah’s Coffee Shop has seller’s discretionary earnings of $131,500.
Add-Backs: Common Points of Contention
The calculation of SDE involves some judgment. Deciding what qualifies as a “discretionary” or “non-recurring” expense can be tricky.
A prospective buyer might push back on certain add-backs. The buyer may see them as vital for the business regardless of who owns it. Add-backs are often the subject of debate between a buyer and seller, but some are fairly straight forward and are really owner’s personal benefit, like networking group memberships and travel.
Establishing Clear Criteria for Add-Backs
To help avoid disputes, make sure each add-back meets these three criteria:
- The add back benefits the owner(s).
- The expense is not of benefit the business or its employees.
- The company pays for these on the company’s tax returns.
If the SDE has varied significantly over the last few years, consider having your accountant calculate a weighted average to get a more stable result.
Increase Sales to Increase SDE
SDE (Seller’s Discretionary Earnings) is a measure of profitability, so it’s crucial to know ways of increasing your company’s SDE and its cash flows. You can grow seller’s discretionary earnings by either increasing revenue or cutting expenses. If done correctly, the financial performance of your company can look immaculate.
Here are ways you can start to manage increasing SDE:
- Evaluate your business’s operations and then cut down any unnecessary expenses.
- Increase revenue by offering a new product or new services. Increase prices as well.
- Negotiate lower prices with your suppliers.
- Encourage all employees to work smarter for a productive increase.
To achieve your business goals, you need to evaluate your business operations, negotiate lower prices, and encourage a productive increase for employees. Consider that by increasing revenue or reducing expenses, the potential buyer will likely be interested.
Navigating the Sale Process
When it comes time to sell, a business broker can be invaluable. They can help prepare a business valuation and assist with all negotiations of the sale. They will review the business financial statements to help ensure compliance and a smoother business transaction.
An experienced broker understands what information to highlight and will also help reduce potential risks for possible investors. They are familiar with what increases business valuation and know the intricacies of the sale process.
Also, remember that you may have to explain your numbers. Make sure you work with an accountant. He or she can give clarity to anything that needs extra documentation so any items in the gray area can be accepted by the buyer.
The cleaner your financials are, the more likely you are to get better sale prices.
As you go through the work to calculate seller’s discretionary earnings for your business, remember this exercise shows you what areas need improvement and documentation. With preparation and possibly some good advice, you’ll be in a great place when the sale happens.
Conclusion
Understanding how to calculate seller’s discretionary earnings is an essential skill. If you are considering selling your business, or are simply wanting to manage working capital, or better understanding your financial performance, mastering the art of calculating SDE is essential for understanding the financial health and market value of your business. With this knowledge, you can confidently approach potential buyers or make well-informed decisions to boost your company’s worth.
