What is (are?) Seller’s Discretionary Earnings?
So, you’re thinking about buying or selling a small business. You’re looking at businesses for sale online, maybe a stiff drink in hand, and you come across an unfamiliar term; Seller’s Discretionary Earnings (aka SDE).
You ask yourself, what does that mean? In plain English, SDE represents the total financial benefit a single full-time owner-operator derives from their business annually.
Typically, I use SDE when talking about a business with less than $1 million in earnings – for larger businesses I use EBITDA. You may also hear me use Seller’s Discretionary Earnings interchangeably with the word cash flow. This is not completely accurate, but SDE is an indication of profitably and can be used as a “proxy” for cash flow.
So where does the number come from? It’s pretty straight forward.
Start With: Net income before taxes
Add: The salary of one full-time owner (do not include dividends)
Plus: Depreciation and amortization
Plus: Interest on long-term debt
Plus: Any one-time expenses that will not reoccur in the future
Plus: Any personal/non-business expenses
You Get: Seller’s Discretionary Earnings.
Think about this. One small business has a net income of about $100k, but the owner doesn’t pay themselves a salary. Another business shows no net income, but the owner receives a $100k salary. On paper, these two businesses look wildly different. But in reality, their earning power is very similar.
SDE attempts to standardize the earnings of a business by excluding items that are variable and discretionary from company to company. So you can compare them on equal footing.
One business may have a heavy debt load while another business may have none. This is why we add back the interest expense on long-term debt.
The same goes for taxes, as each business will use a different tax strategy. This is why we use pre-tax earnings.
Depreciation and Amortization are non-cash expenses, so we add that back as well because no cash is actually spent.
Finally, the owner’s salary and personal expenses will vary greatly from business to business, and those expenses will no longer exist when the owner is removed. So they are added back as well.
But you’ve got to be careful. Many people, including brokers, make mistakes and use SDE incorrectly. Common pitfalls include:
Overstating Add-Backs: Not every expense qualifies. Only include those that are truly discretionary or non-recurring.
Poor Documentation: Be prepared to back up your add-backs with receipts or explanations. Or they don’t exist.
Weird Salaries: If the owner’s salary is below (or above) market rate, adjust accordingly to reflect what a new owner might pay themselves or a manager.
So what does all this mean to a business buyer? Seller’s Discretionary Earnings is essentially how much cash a business generated in a given year, and is the amount of money that a buyer has to:
Pay themselves a salary
Service debt
Cover any capital expenditures that may be required
Generate a return on their initial down payment invested
Imagine you’re analyzing the financials of a business that you would like to buy. If the business generates enough cash to pay yourself, pay your debt, cover any upcoming capital expenditures (if applicable), and generate a reasonable return on the cash you invested, would you buy it?
Many factors go into the decision to buy a business, but financially, this sounds like a fair deal.
Disclaimer: I am (thankfully) not a lawyer, nor am I an accountant. If any of this sounds like legal/financial advice, it's not. Take everything I say with a grain of salt. But not too much - I hear it's bad for your blood pressure.
