What is Seller's Discretionary Earnings & Why is it the Most Important Driver of Small Business Value?
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Definition
Seller’s Discretionary Earnings (“SDE”) is an estimate of the total financial benefit a full time owner operator would derive from the business on an annual basis. It is also variously referred to as Seller’s Discretionary Cash Flow, Adjusted Cash Flow, Owner Benefit, Recast Earnings or Normalized Earnings, although Seller’s Discretionary Earnings is the official terminology advocated by the International Business Broker’s Association (IBBA).
Calculation
The IBBA has defined how SDE is to be calculated. A business’s overall SDE is generally calculated as an average of the SDE for the 3-5 most recent years. If there is a strong trend in the earnings (up or down), much more weight tends to be placed on more recent years. SDE is calculated for each year based on information from the business tax returns, the profit and loss statements (P&Ls), other financial records and owner estimates.
The SDE for each year is calculated as follows:
- Owner compensation, salary, profit sharing, etc. (i.e., cash consideration) paid to all the owners, less the salary of any employee(s) needed to replace a 2nd or 3rd (etc.) owner, plus
- Employer portion of payroll taxes paid based on the W2 salary of one owner, plus
- Pretax net income, plus
- Interest expense (because business debt is a “non operating expense” and assumed to be paid off), plus
- Depreciation and amortization (non cash expenses), plus
- “Discretionary expenses” or perks that meet four criteria. They: 1) benefit the owner, and 2) are paid for by the business, and 3) are reported on the tax returns and P&Ls, and 4) do not benefit the business. Common examples include:
- Health and/or life insurance for one owner/ owner’s family
- Personal use of automobiles
- Personal travel, meals and entertainment
- Personal use/consumption of products/ services
- Any other personal expense
- Family members on the payroll but not really working in the business, or the portion of their earnings that are above market wage
- Plus
- Adjustments for extraordinary, non recurring expenses or revenue (e.g., expenses from a rare lawsuit or flood damage would be added back; revenue and expenses from a major discontinued product would be removed)
It's important to note that banks and other financing sources will ignore completely the portion of SDE derived from "discretionary expense" add backs and, in many cases, extraordinary expenses. Many buyers will discount the value of these expenses to varying degrees. Many business sellers, buyers and even business brokers calculate SDE incorrectly.
Mistakes in Calculation
Common mistakes include:
- Not adjusting properly for more than one owner or an absentee owner
- Counting as discretionary expenses that actually benefit the business (e.g. country club or Rotary membership dues, when clients come from those sources)
- Counting as discretionary all expenses of a certain type, such as auto, travel and meals/ entertainment, when some of those expenses were necessary for or benefited the business
- Counting both owner draws and pretax earnings (which is double counting)
- Adding unreported cash sales to SDE, unless the buyer has a straightforward means to verify such sales.
- Adding back as an extraordinary expense failed marketing or advertising programs (since there is no way to verify the impact of the programs).
Importance of SDE
The first (and often the second and third) thing most buyers want to know about a business is “how much money will I make”? The best answer to that for a small business is Sellers Discretionary Earnings. SDE is the most accurate predictor and driver of the value of a small business.
SDE is used by business brokers and appraisers nationwide to value businesses, and is reported in “comps” databases that enable (to the extent possible) “apples-to-apples” comparisons of various business sales prices.
Limitations
As explained in detail elsewhere on this site, there is no simple formula to accurately value businesses, and a great many other factors besides SDE can be important.
In a minority of business sales, the historical SDE is irrelevant or a very minor factor, as most of the value is in key transferable assets, such as a below market lease, equipment or a limited permit or license, that could be used by certain buyers to make much greater profit than the current owner. But this is the exception. Usually, if assets don’t generate profits, they are worth only their liquidation value.
It is also a mistake to assume the SDE is what the owner gets to “put in his pocket”. Taxes and funds for reinvestment in the business, such as for new equipment or to finance growth, both come out of SDE.
