There are several ways to determine the value of a business, but one of the most commonly used metrics in business valuation is Seller’s Discretionary Earnings (SDE). This metric helps potential buyers determine how much money they will take home if they purchase the business.
SDE is different from taxable income or book income. We’ll examine what SDE is, how you determine it, and why it matters.
What is SDE in Business?
Seller’s Discretionary Earnings, at its core, represents the total earnings that a business owner can potentially take home from a company. Think of it as the cash left over after paying for all the necessary expenses associated with running a business.
SDE is calculated before considering interest, taxes, depreciation, and amortization factors. It provides a snapshot of the business’s profitability by adding back certain discretionary expenses, which offers a clearer picture of the company’s actual earning potential.
This metric is especially favored by potential buyers and investors when evaluating small to medium-sized businesses. It allows potential investors to gauge the true profitability of a business and estimate the potential return on their investment.
You price many business sales at a multiple of SDE. The multiple used will vary greatly depending on the business’s industry and size. Smaller businesses usually sell for lower multiples since they are more risky.
The Components of Seller’s Discretionary Earnings
It’s critical to understand the various elements that come into play during its calculation:
- Net Income: This serves as the starting point for any SDE calculation. It represents the company’s total earnings after all deductions.
- Owner’s Salary and Benefits: Since the compensation given to business owners can vary widely based on personal choices and business strategies, it’s added back to the net income. If the owner is actively involved in the business, it may be possible to adjust to cover the cost of a new employee to replace the owner.
- One-time or Non-recurring Expenses: These expenses should not recur in the foreseeable future. Adding them back ensures they don’t skew the perception of ongoing profitability. Examples are one-time repair bills, settlement (income or expenses), and grants.
- Discretionary Expenses: These are costs that, while they might have been incurred, are optional for the business’s day-to-day operations. (This may include expenses such as the owner’s cellphone or vehicle, which are justifiable business expenses but may not be required to operate the business).
- Interest, Taxes, Depreciation, and Amortization: You add these elements back as they can differ based on various factors like business structure, financing decisions, and more. They generally don’t apply to a new owner unless the new owner assumes the company’s existing financing arrangements.
How to Calculate SDE
To calculate SDE, you’ll complete the following steps:
Begin with the net income of the business. You’ll want to ensure that the accounting is complete and you book all journal entries for the period you are using. Using the prior year or a year-to-date profit and loss is common as the starting point.
Add the owner’s salary and any additional benefits they might receive. Additional benefits commonly include insurance, retirement contributions, travel reimbursements, or vehicle expenses. Remember also to consider the payroll taxes on the owner’s salary, which could be significant depending on the salary.
Incorporate any one-time or non-recurring expenses that the business might have incurred. You’ll need to use your judgment to determine which expenses are truly one-time events. Ensure to evaluate any one-time income events that you should remove from ongoing operation projections. One-time income events include bonus payments or government grants. Forgiveness of Paycheck Protection Loans and EIDL grants are common, recent examples of one-time income.
Factor in any discretionary expenses. These could range from business trips that mix leisure with work to expenses on non-essential software.
Lastly, add back any interest, taxes, depreciation, and amortization amounts.
Let’s look at a simple example. Consider a business that shows a net income of $100,000, an owner’s salary of $50,000, one-time expenses amounting to $10,000, and a depreciation value of $5,000, the SDE calculation would yield a total of $165,000 ($100,000 + 50,000 + $10,000 + $5,000). If businesses of this size and in this industry typically sell for three times earnings, the value of the business would be $495,000 ($165,000 * 3).
How to Analyze SDE
It is important to realize that SDE is not a black-and-white calculation. There is plenty of room for interpretation of various categories of expenses and transactions. Remember that sellers will want to show the highest possible SDE and may minimize the necessity of certain expenses.
A higher SDE typically indicates a more profitable business, making it an attractive proposition for potential buyers or investors. When engaged in sale negotiations or valuation discussions, SDE can serve as a robust tool to showcase the business’s profitability and potential.
The Downsides of SDE as a Valuation Metric
While SDE is undeniably valuable, it’s not without its limitations.
SDE focuses heavily on past results and current earnings, which means it might not always accurately capture a business’s future growth potential or trajectory.
The discretionary expenses you add back can vary based on interpretation, leading to different SDE values for the same business. Remember that the buyer and seller have different motivations when calculating SDE.
Other metrics like EBITDA might be more appropriate and insightful for larger corporations with intricate structures and diverse revenue streams.
Closing Thoughts on What is SDE in Business
Seller’s Discretionary Earnings offers a nuanced and detailed perspective on a company’s profitability. However, like all tools, its efficacy maximizes when used in conjunction with other metrics and insights.
For those looking to dive deep into business valuation, whether for sale, investment, or strategic planning, consulting a seasoned financial advisor or business valuation expert can provide a holistic view. Such professionals can guide you through the intricacies of SDE and ensure that you’re making informed and strategic decisions.