5 minute read

Seller's Discretionary Earnings (SDE): An Overview

Business owners naturally want their business to fetch top dollar when they sell. On the other hand, buyers want to pay the lowest price possible and must be convinced of the business's value. One way to cross that divide is by presenting buyers with an estimate of the cash they can expect their new business to generate for them.

Seller’s discretionary earnings (SDE) helps to show how much money a business buyer will be able to pocket at the end of the day. It can help justify the sale price of a business and convince buyers of the company's value.

Unlike a profit and loss (P&L) statement, SDE lets buyers see only necessary business expenses, not the discretionary items or personal expenses specific to the seller.

What Are Seller’s Discretionary Earnings?

Seller's discretionary earnings is a metric used by owner-operated businesses to measure the full financial benefit a business generates for its owner. It is calculated by using the company's net profit and then adding back certain bottom-line expenses. These include items such as:

• Owner’s compensation
• Business travel
• Health insurance
• One-time expenses (or non-recurring expenses), like equipment upgrades
• Interest
• Amortization and depreciation

How SDE Affects Business Value

Preparing an SDE is essential to valuing a small business. The sale price of any business is often benchmarked by comparing its financial performance to recently sold businesses in the same industry and market. Cash flow is usually the most important metric, and SDE is 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 will be.

For example, suppose Jane, the owner of Jane's Spa, pays herself $100,000 yearly. Jane also likes to attend an annual spa owners conference in Hawaii (for which she typically spends $6,000), and throws an elegant, catered holiday party for clients at about $4,000. 

A potential buyer reviewing the P&L statement for Jane's Spa would see that the company's net income was $200,000 (because Jane's salary, trips, and parties were deducted as expenses). But the SDE would show income of $310,000 as a result of adding back the discretionary expenses. 

Let's say that businesses in the spa industry typically sell for a multiple of two times cash flow. Using SDE of $310,000 and a multiple of two, the value of Jane's Spa amounts to $620,000. Because the SDE is multiplied, adjustments to the SDE calculation can have an outsized effect on the valuation.

When is EBITDA Used?

EBITDA (earnings before interest, taxes, depreciation, and amortization) is also calculated by excluding certain expenses. The primary difference is that the EBITDA valuation method doesn’t exclude the owner’s compensation.

Businesses with earnings over one or two million dollars will often use EBITDA as an evaluation metric because buyers rely on professional managers to run the operation. Businesses at this valuation level are typically purchased by private equity or competing businesses, both of which would count on having to pay a new manager to replace the owner-operator.

All other things being equal, SDE will generally be higher than EBITDA. But the multiples applied to SDE calculations are typically lower than those involved when an adjusted EBITDA is used. 

How to Calculate SDE

Calculating SDE starts with the net profit the business generates before taxes. Discretionary expenses are then added back to the bottom line. This is known as recasting. Expenses that can be added back, or recast, include:

• The owner’s salary, including perks such as health insurance, automobiles, and fuel
• Expenses that aren’t necessary for running the business, like the cost to attend trade shows, other travel, and charitable contributions
• One-time expenses that are not likely to recur, such as upgrades to a website
• Interest on loans the owner carries
• Taxes such as payroll taxes the company pays on the owner’s salary
• Depreciation and amortization

Direct business operating expenses, like rent and utilities, plus the discretionary add-backs equals the SDE. 

Here’s how the calculation might work for Brenda’s Pet Supply:

Gross revenues for Brenda’s in the most recent year totaled $800,000.

Add-backs included:

• The owner’s salary of $100,000
• $500 for phone and internet expenses, representing the portion the owner and his family spend for their personal use
• The cost to attend an annual trade show for $6,000
• $400 for IT services to repair the computer system after it crashed
• A $400 one-time cost to replace the store’s outdoor signage when it was damaged in a storm.

The table below illustrates the effect of add-backs on the company’s operating expenses and SDE:

Add-Backs May Be a Point of Contention

While it’s a generally accepted practice to use add-backs to prepare an SDE statement, what passes as an add-back is open to dispute. Prospective buyers can argue that expenses such as business travel are necessary regardless of who owns the business.

In general, add-backs should meet these criteria:

• Be incurred for the benefit of the owner, not the business or its employees
• Be paid for by the business
• Show as expenses on the company’s tax returns and income statement

So-called standard add-backs, like the owner’s salary and depreciation on business property, are straightforward and rarely disputed.

Similarly, buyers are likely to agree with discretionary items on the financial statements, such as health insurance, retirement account contributions, health club dues, and charitable contributions, as long as these items also appear on tax returns as deductions. 

Non-recurring and non-essential items, however, might well be open to dispute. It’s important to have a qualified CPA or business broker prepare these financial statements to ensure legal and financial compliance. To learn more about what to add-back to get a realistic SDE, see Add-Backs for Seller’s Discretionary Earnings.

---