Whether you are a potential buyer or seller, you are probably asking yourself the same question: “What is this business truly worth?”
Unfortunately, the answer is not as straightforward as we might hope. Business valuation is an inexact science with plenty of room for subjectivity. However, there is a framework for determining the financial worth of a company. And this framework begins with the calculation of seller’s discretionary earnings (SDE).
But what is SDE, and how is it calculated? That’s what we are here to discuss. This article covers the concept of seller’s discretionary earnings and why it is a critical component of business valuation. We will walk through an example calculation and demonstrate how SDE provides a valuation range for buyers and sellers to consider.
Understanding Seller’s Discretionary Earnings
Seller’s discretionary earnings is a crucial metric in business valuation, specifically for small businesses with less than $3 to $5 million in revenue. However, understanding SDE can be a little tricky, so let’s first reflect on the objective of the calculation.
Definition of SDE
SDE is a way to measure how much money a small business truly makes. Not how much income the business reports for the financial year, but how much money is actually available to the owner. These are the total earnings that can be used at the business owner’s discretion.
The goal of SDE is to remove all of the nuances of the current owner’s management practices. This allows potential buyers to get an accurate picture of past financial performance, without the effects of financing charges, discretionary spending, and other variables that may not affect them.
Adjustments to SDE
SDE is calculated by making four key adjustments to pre-tax income. Let’s analyze each one of them:
Owner’s Salary and Benefits
One of the primary elements of SDE is the salary and benefits that a business owner receives. This can encompass a broad array of perks, such as health insurance, Simple IRA or 401k contributions, or even personal vehicle usage.
Note: If the business is run by two (or more) owners who both draw salaries, we will only add back the salary of one owner. Or, to be more precise, we can add back both salaries and then deduct the market rate of replacing one of the owners with a manager. This adjustment is required to reflect the true earning power of the business if it were to be acquired by a single new owner.
Non-operating or Discretionary Expenses
Non-operating expenses, or discretionary expenses, are costs that arise from activities not related to the core business operations. Discretionary expenses may include interest payments on loans or personal expenses that the owner charged to the business, like travel or a car lease. These expenses would not necessarily be incurred by a new owner, so they are added back to SDE.
Non-cash expenses, like depreciation and amortization, are accounting practices that reduce a company’s reported income but do not involve any cash outflow. Adding these expenses back to SDE helps paint a more accurate picture of the company’s cash flow.
Occasionally, businesses incur expenses that are not part of their ongoing operations. These can be legal fees, moving expenses, the costs of an extensive website redesign, or even a one-off Google Shopping test. Deducting these expenses from SDE would be overly punitive to the valuation of the business, given they are not likely to be repeated in the future.
How to Calculate Seller’s Discretionary Earnings
Now that we have an understanding of the various components that contribute to SDE, let’s delve into the calculation process. To determine the SDE of a small business, follow these simple steps:
1) Begin with the company’s net income (before taxes).
2) Add back the owner’s salary and benefits (or the adjusted salary amount for multiple owners, as mentioned earlier).
3) Add back non-operating expenses.
4) Add back non-cash expenses.
5) Add back non-recurring expenses.
6) The sum of these values represents the Seller’s Discretionary Earnings.
Sample SDE Calculation
If you want to determine how much your website is worth, you first must calculate your SDE. Here’s a hypothetical scenario to illustrate how this is done:
1) Net income (before taxes)
On the most recent year’s income statement, find the target company’s bottom line. If state or federal income taxes have already been deducted from net income, we must add them back in.
And if the company reported a loss to the IRS, don’t let that mislead you. With the following adjustments, we may still arrive at a positive SDE and a positive business valuation.
Let’s say the pre-tax income of Company A is $120,000.
2) Owner’s salary and benefits
Assume Company A’s current owner receives an annual salary of $60,000. However, they also receive health insurance, retirement contributions, and vehicle reimbursements, which total $20,000.
To calculate SDE, we will add back the full amount of $80,000.
3) Non-operating expenses
Company A purchased a piece of expensive machinery with a bank loan a few years ago. This year, the interest payments on that loan amounted to $7,000. The owner also charged some personal travel to the business that totaled $3,000.
We will add $10,000 in non-operating expenses back to SDE.
4) Non-cash expenses
Due to the depreciation of its machinery, Company A reported a non-cash expense of $20,000 last year.
We will add $20,000 in non-cash expenses back to SDE.
5) Non-recurring expenses
Company A also settled a trademark dispute last year. The one-time legal fees associated with this dispute totaled $15,000.
We will add $15,000 in non-recurring expenses back to SDE.
6) Calculating seller’s discretionary earnings
$120,000 (pre-tax income) + $60,000 (owner’s salary) + $20,000 (owner’s benefits) + $10,000 (non-operating expenses) + $20,000 (non-cash expenses) + $15,000 (non-recurring expenses) = $245,000
In this example, the seller’s discretionary earnings for Company A amount to a whopping $245,000 — that’s more than double the net income figure!
Common Mistakes to Avoid when Calculating SDE
To make sure your SDE calculation is as accurate as possible, keep an eye out for these common mistakes:
- Not accounting for all owner benefits: Be thorough in identifying all the perks enjoyed by the owner, as underestimating these can lead to undervaluing the business.
- Over-adjusting for multiple owners: When a business has multiple owners drawing salaries, we cannot simply add all of their salaries back to SDE. After all, the future owner will have to pay someone to help them take over these responsibilities.
- Ignoring non-recurring expenses: It’s important to identify and agree upon one-time expenses that are unlikely to be repeated in the coming years. This will provide a more consistent representation of the company’s finances.
How to Value a Business Using Seller’s Discretionary Earnings
So you’ve painstakingly calculated SDE, but what now? How do we use this figure to determine a business’s value?
The next step is to apply a valuation multiple to the SDE. Here’s how to think about that process:
Applying a Valuation Multiple to SDE
To arrive at a business’s value, we need to multiply the calculated SDE by a fair valuation multiple. Again, what qualifies as fair is a bit subjective.
If you are selling your business, you have every incentive to defend a higher multiple. On the other hand, if you are considering buying a business, you will likely look for reasons to propose a lower multiple.
Ultimately, the range of multiples used in business valuations depends on several factors:
- Business model
- Business size
- Growth prospects
- Growth rate
- Risk level
As you might be able to tell, calculating SDE is often the less contentious part of the valuation process. Applying a valuation multiple calls for judgment, negotiation, and compromise.
Fortunately, Flippa has analyzed its historical sales data and created guidelines for different business types. Content businesses sell for an average of 1.95x SDE, eCommerce businesses for 1.85x SDE, and SaaS businesses for 2.7x SDE.
Note: For examples of transactions within this range, read Flippa’s official guide on How To Sell A Business.
Adjusting the Multiple with Comps
Comps, or comparable transactions, are a great way to hone in on the market price of a business.
If you can find three meaningful comps — businesses that have sold recently that are similar in size, business model, industry, and growth — then you can use those multiples as a good starting point for your negotiations.
For example, if the target site is an eCommerce business, we know that the average SDE multiple is 1.85x. But if the business is growing quickly and in a desirable niche, then we would expect the valuation multiple to be above average.
How much above average? That’s where comps can come in and help determine what is realistic in today’s market. Perhaps businesses with comparable growth potential and competitive advantages are selling for closer to 2.5x or 3.0x SDE.
These reference points can be helpful for potential buyers when placing a bid and for sellers in setting their expectations.
Limitations of SDE in Business Valuation
Although SDE is a helpful metric in business valuation, it’s crucial to recognize its limitations. A few primary limitations include:
- Subjectivity: The adjustments made to SDE can sometimes be subjective. For example, a seller may consider an expense non-recurring but the potential buyer may disagree.
- Not applicable for larger businesses: SDE is most useful for small businesses with revenues of $3 to $5 million or less. For larger businesses with more complex organizational structures, other valuation methods like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) are more appropriate.
- Ignores intangible assets: SDE focuses on financial metrics and does not account for intangible assets like brand value, customer relationships, or intellectual property. These intangible assets can have significant value but are not captured in the SDE calculation itself.
- Assumes continued business operations: SDE assumes that the business will continue operating as it has been under the current owner. However, a new owner may introduce changes that could impact the business’s earning potential, rendering the SDE calculation less accurate.
How Buyers and Sellers Can Benefit from Understanding SDE
An in-depth comprehension of seller’s discretionary earnings can offer significant advantages to both buyers and sellers in a business transaction. By being well-versed in the concept of SDE, both parties can approach negotiations with a more accurate understanding of a business’s true value. Let’s explore the benefits of SDE knowledge for both buyers and sellers.
Assessing the true profitability of a business
To evaluate any income-producing asset, the buyers must be able to determine its actual profitability. SDE offers a more accurate depiction of a company’s income by incorporating adjustments for the owner’s salary and benefits, non-operating expenses, non-cash expenses, and non-recurring expenses. By understanding SDE, buyers can make better-informed decisions about the long-term viability of a business.
Identifying potential areas for improvement and growth
By dissecting the different components that contribute to SDE, buyers can pinpoint potential areas for growth and improvement within a business. For instance, they might identify non-operating expenses that could be trimmed or excessive one-time costs that can be avoided in the future. This knowledge can empower buyers to create a more profitable and efficient business post-acquisition.
Finding a fair purchase price based on SDE
Armed with the knowledge of SDE, buyers can engage in discussions with a more solid foundation. By understanding the true earning potential of a business, buyers can confidently propose a purchase price that reflects the company’s value. SDE allows buyers to avoid overpaying for a business and ensures that they are making a well-informed investment.
Properly presenting the business’s financial health
Sellers must be able to accurately showcase the financial health of their business to attract potential buyers. By calculating and presenting the company’s SDE, sellers can provide a more comprehensive view of the business’s true profitability. This enables buyers to see past the limitations of traditional financial statements and appreciate the full potential of the business.
Justifying the asking price based on SDE
By using SDE as a basis for valuation, sellers can defend their asking price with confidence. Demonstrating how the calculated SDE supports the business’s value ensures that sellers are not leaving money on the table and helps facilitate smoother negotiations with buyers. It also narrows the focus of the discussion to determining a fair multiple, given recent market trends.
Identifying areas to optimize before listing the business for sale
Understanding SDE can help sellers identify areas in their business that may need optimization before listing it for sale. By examining the various components that contribute to SDE, sellers can recognize opportunities for improvement, such as reducing non-operating expenses or eliminating non-recurring costs. By making these changes, sellers can minimize the chance that buyers try to reduce the business’ valuation by debating the validity of certain adjustments.
Calculating seller’s discretionary earnings is the first step in determining the value of a small business. By aligning on this figure and the adjustments required to get there, buyers and sellers can come to a clearer understanding of the true earnings of an organization.
As you venture into your next business transaction, remember the important role SDE plays in the price discovery process. It’s a powerful tool that can help you make smarter decisions and create successful business outcomes. So embrace the power of SDE, and take on your next deal with confidence. Best of luck!
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