Seller discretionary earnings

What Is Seller Discretionary Earnings?

Seller discretionary earnings (SDE) is a financial metric used primarily in business valuation, particularly for small businesses with active owner-operators. It represents the total financial benefit an owner-operator receives from a business, before certain non-operating or discretionary expenses. The purpose of calculating seller discretionary earnings is to provide a clear picture of the cash flow available to a single owner, allowing potential buyers to compare different businesses on a more apples-to-apples basis, irrespective of the current owner's specific compensation structure or personal expenses. SDE aims to normalize a business's profitability by adding back costs that a new owner might not incur or that are considered discretionary.

History and Origin

The concept of seller discretionary earnings emerged as a practical tool within the realm of small business acquisitions, rather than from a formal academic or regulatory body. Its adoption gained traction due to the unique financial structures often found in owner-operated small businesses, where the owner's personal expenses or compensation may be intertwined with the business's financials. Unlike larger corporations with distinct management layers, a small business owner often performs multiple roles, blurring the lines between salary, perquisites, and profit. Over time, as the market for buying and selling small businesses matured, the need for a standardized metric that could accurately reflect the true earning potential for a new owner became apparent. This led to the widespread use of SDE, particularly by business brokers and intermediaries, to help prospective buyers understand the true "take-home" income generated by a business. The U.S. Small Business Administration (SBA) often requires independent business valuations for loans exceeding a certain threshold for business acquisitions, and SDE is frequently a cornerstone of these valuations.¹⁰

Key Takeaways

• Seller discretionary earnings (SDE) is a key metric for valuing small, owner-operated businesses.
• It quantifies the total financial benefit an owner-operator receives from a business.
• SDE is calculated by starting with net income and adding back specific expenses like owner's compensation, non-cash expenses, and certain discretionary or non-recurring costs.
• The primary goal of SDE is to normalize a business's true cash flow for a prospective owner, facilitating comparisons between different opportunities.
• SDE is a common input for valuation multiples in the small business market.

Formula and Calculation

The formula for calculating seller discretionary earnings starts with the company's net income and adjusts it by adding back specific expenses. This process helps to present the earnings as if a single owner-operator were running the business.

The general formula is:

Where:

• Net Income: The business's profit after all operating expenses, interest expense, taxes, depreciation, and amortization have been deducted.
• Owner's Compensation: Includes salary, wages, and all benefits or perks (such as health insurance, vehicle expenses, personal travel) paid to the owner, beyond a market-rate salary for any other employees who would replace the owner's operational duties. Only one owner's compensation is typically added back.⁹
• Interest Expense: The cost of borrowing money for the business. This is added back because a new owner might have a different financing structure.
• Depreciation: A non-cash expense that accounts for the reduction in value of tangible assets over time.
• Amortization: A non-cash expense that accounts for the reduction in value of intangible assets over time.
• Non-recurring Expenses: One-time expenses that are unlikely to occur again under new ownership, such as a major repair due to an unforeseen event or legal fees for a unique lawsuit.⁸
• Discretionary Expenses: Expenses that are not strictly necessary for the operation of the business and were incurred at the owner's discretion, such as excessive travel, memberships, or donations. These are often referred to as add-backs.

Interpreting the Seller Discretionary Earnings

Seller discretionary earnings provides a vital snapshot of a small business's underlying financial performance, indicating the total financial benefit available to an active owner-operator. When interpreting SDE, it is crucial to understand that it represents the "total owner benefit," not just salary or profit. This means it encompasses the owner's salary, any personal perks run through the business, and the profit left over before taxes and debt service.

Buyers use SDE as a foundational figure to determine what they could realistically earn from the business. A higher SDE generally indicates a more profitable and attractive business from an owner's perspective. It allows buyers to compare different small businesses on a normalized basis, as it strips away the impact of varying owner compensation and financing structures. For instance, two similar businesses might have different net incomes on paper, but after adjusting for owner-specific expenses through SDE, their true owner benefit might be comparable. This metric is especially valuable in industries where owner involvement is significant, and personal and business finances can easily intertwine. It’s a critical component in estimating the fair market value of a business by applying an industry-standard multiple to the SDE figure.

⁷## Hypothetical Example

Imagine Jane wants to sell her small graphic design business, "Creative Canvas," and a potential buyer, Mark, is performing due diligence.

Here are Creative Canvas's simplified financials for the past year:

• Revenue: $300,000
• Operating Expenses (excluding owner's salary, interest, depreciation, amortization): $150,000
• Owner's Salary: $80,000
• Owner's Health Insurance (personal benefit): $5,000
• Company Car Lease (partially personal use): $6,000 (assume $3,000 is for personal use, an add-back)
• Interest Expense: $2,000
• Depreciation: $4,000
• Amortization: $1,000
• One-time Legal Fee (settlement for old contract dispute): $3,000
• Taxable Income (Net Income before taxes):
  $300,000 (Revenue) - $150,000 (Operating Expenses) - $80,000 (Owner's Salary) - $5,000 (Health Insurance) - $6,000 (Car Lease) - $2,000 (Interest) - $4,000 (Depreciation) - $1,000 (Amortization) - $3,000 (Legal Fee) = $49,000

Now, let's calculate the seller discretionary earnings (SDE) for Creative Canvas:

1. Start with Net Income (before taxes): $49,000
2. Add back Owner's Salary: +$80,000
3. Add back Owner's Health Insurance: +$5,000
4. Add back Personal Portion of Company Car Lease: +$3,000
5. Add back Interest Expense: +$2,000
6. Add back Depreciation: +$4,000
7. Add back Amortization: +$1,000
8. Add back One-time Legal Fee: +$3,000

So, the seller discretionary earnings (SDE) for Creative Canvas is $147,000. This is the figure Mark, the potential buyer, would use to assess the total financial benefit he could expect from owning and operating the business, assuming he replaces Jane's functions.

Practical Applications

Seller discretionary earnings (SDE) is extensively used in the valuation and sale of small businesses, particularly "Main Street" businesses that are typically purchased by an owner-operator. Its applications include:

• Setting Asking Prices: Business brokers and sellers frequently use a multiple of SDE to arrive at an initial asking price. For example, a business with $150,000 in SDE might be listed for sale at 2.5 times SDE, or $375,000. Industry-specific multiples of SDE are commonly published and referenced in the market.
  *⁶ Buyer Assessment: Prospective buyers rely on SDE to understand the total cash flow available to them as the new owner. This helps them determine if the business can generate sufficient income to cover their living expenses, debt service from the acquisition loan, and provide a return on their investment.
• Loan Underwriting: Lenders, especially those providing Small Business Administration (SBA) loans for business acquisitions, often use SDE as a primary metric to assess the business's ability to service debt. They typically require an independent business valuation that relies heavily on SDE. T⁵he SBA provides guidance on business valuations when selling a business, underscoring the importance of accurate financial assessments.
  *⁴ Negotiation Basis: SDE serves as a common language and starting point for negotiations between buyers and sellers. While the final price may involve adjustments, SDE anchors the discussion around the business's true earning power for an owner.
• Performance Benchmarking: Owners can use SDE to benchmark their business's performance against industry averages for similar-sized owner-operated businesses, helping them identify areas for improvement or understand their competitive position.

Limitations and Criticisms

While seller discretionary earnings (SDE) is a widely used and valuable metric for small businesses, it has several limitations and criticisms:

• Subjectivity of Add-Backs: The most common criticism is the subjectivity involved in determining what constitutes a "discretionary" or "non-recurring" expense. Sellers might be tempted to include too many add-backs, inflating the SDE. Conversely, buyers may dispute these adjustments. For example, a "one-time" expense for an equipment repair might be an infrequent but necessary capital expenditure that a new owner would eventually face.,
  ³*² Not Suitable for Larger Businesses: SDE is specifically designed for owner-operated small businesses where the owner's role is central and their compensation structure might be informal. It becomes less relevant for larger companies with professional management teams, complex organizational structures, and substantial working capital needs, where metrics like Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) are more appropriate.
  *¹ Ignores Future Management Costs: While SDE adds back the owner's current compensation, it assumes a new owner will perform the same duties or that a replacement manager could be hired for a similar amount. If the new owner needs to hire additional staff or pay a higher salary for a manager to take over the previous owner's responsibilities, the true discretionary earnings for the buyer could be lower than the reported SDE.
• Doesn't Account for Future Capital Needs: SDE adds back depreciation and amortization, which are non-cash expenses. However, businesses still require ongoing investment in assets. If a business has significant future capital expenditures for equipment replacement or upgrades, ignoring these needs by adding back depreciation can paint an overly optimistic picture of future cash available to the owner.
• Reliance on Historical Data: SDE is typically calculated using historical financial data. While useful, it doesn't inherently account for future market changes, economic shifts, or new competition that could impact the business's future profitability. Buyers must conduct thorough due diligence beyond just the SDE calculation.

Seller Discretionary Earnings vs. Earnings before interest, taxes, depreciation, and amortization (EBITDA)

Seller discretionary earnings (SDE) and Earnings before interest, taxes, depreciation, and amortization (EBITDA) are both measures of a company's financial performance, but they serve different purposes and are applied to different types of businesses. The primary distinction lies in their intended audience and the level of owner involvement they account for.

EBITDA is a broader measure of operating profitability before the effects of financing, accounting decisions (depreciation and amortization), and taxes. It is widely used in the valuation of larger companies, where there is a clear separation between ownership and management. EBITDA focuses on the operating performance of the business itself, regardless of how it's financed or what the owner's specific compensation looks like.

SDE, on the other hand, is a more tailored metric for small businesses that are typically owner-operated. It takes EBITDA as a starting point (or derives a similar figure by adding back interest, depreciation, and amortization to net income) but then goes further by adding back the owner's total compensation, personal benefits, and any other non-essential or one-time expenses that were incurred at the owner's discretion. The goal of SDE is to show the total financial benefit an active owner-operator receives, providing a clearer picture for potential owner-buyers. While both metrics aim to normalize earnings, SDE specifically normalizes for the owner's direct financial involvement and discretionary spending, which is less relevant for larger, professionally managed enterprises.

FAQs

What type of businesses typically use Seller Discretionary Earnings?

Seller discretionary earnings is most commonly used for valuing small, owner-operated small businesses, often referred to as "Main Street" businesses. These are typically businesses where the owner is actively involved in daily operations and where their personal expenses or compensation might be intertwined with the business's financials.

Why are owner's salary and benefits added back to Net Income for SDE?

Owner's salary and benefits are added back to net income when calculating SDE to provide a standardized view of the business's total cash generation. In small, owner-operated businesses, the owner's compensation can vary widely and may include personal expenses. By adding these back, SDE shows the total amount of money available to a new owner, regardless of how the previous owner chose to pay themselves or run their personal expenses through the business. This helps potential buyers assess the true underlying cash flow available to them.

Is Seller Discretionary Earnings the same as profit?

No, seller discretionary earnings is not the same as simple profitability or net income. While it starts with net income, it adds back specific expenses such as the owner's compensation, non-cash expenses (like depreciation and amortization), interest expense, and any non-recurring or discretionary expenses. The aim is to show the total financial benefit available to an owner-operator, which is often significantly higher than reported net income, especially in small businesses.

Can SDE be negative?

Theoretically, SDE can be negative if a business consistently operates at a loss even after adjusting for all the discretionary and non-cash items. However, a business with a consistently negative SDE would typically have very little, if any, market value for an owner-operator buyer, as it would imply the business cannot generate enough income to cover operational costs or compensate an owner.

How does SDE affect the selling price of a business?

Seller discretionary earnings is a primary driver of the selling price for many small businesses. Business brokers and appraisers commonly use valuation multiples applied to SDE to determine a business's market value. A higher, well-supported SDE generally leads to a higher valuation and therefore a higher potential selling price, as it signifies greater financial benefit and cash flow potential for a prospective buyer.