VALUING YOUR BUSINESS:
Determining Seller Discretionary Earnings
by Matteo Valles · Updated Nov. 3, 2020
Seller Discretionary Earnings (SDE) or annual owner earnings is the most important step to calculating the value of your business.
Understanding how to determine your SDE will allow you to track the value of your business and grow it before selling.
Below we’ll walk through the difference between SDE and EBITDA, how to calculate SDE, and an example from a P&L.
1. Seller’s Discretionary Earnings vs. EBITDA
You hear a lot about EBITDA and EBITDA multiples when a business is sold, but that isn’t as important with small businesses.
What really matters is the total financial benefits package that the owner of the business receives annually.
Why the difference?
Larger businesses (starting around $1,000,000 EBITDA), tend to be part of a portfolio of investments and normally are not owner-operated.
Due to their size, these businesses also tend to be more stable and command more market share. This usually causes them to have a higher multiple attributed to EBITDA.
With smaller businesses (<$1,000,000 EBITDA), these tend to be purchased by people looking to own a single company, working full-time in the business, and supporting their family off the income.
This leads to 2 outcomes:
Lower multiples due to the increased risk the buyer is taking on (the ability to support their family is riding on the business’s success)
Larger focus on how much money a buyer would expect to earn/save. Otherwise known as SDE.
While a slightly different method, Warren Buffet even analyzes owner earnings despite valuing the world’s largest companies!
2. Calculating SDE
The foundation of SDE always starts with net profit.
But most likely, your net profit doesn’t tell the whole story about the financial package that the company provides you.
To get the full picture, you have to take net profit and add in what's called “add-backs”.
Add-backs are expenses that are either discretionary, provide benefit to the owner, or something that a buyer would not have to pay for in the future.
Some add-backs are straightforward and considered typical, whereas others are circumstantial.
One Owner’s Salary - Smaller businesses are assumed to be owner-operated. Therefore, whatever salary the owner is currently making is added back into the total financial package or SDE.
Payroll Taxes - We must account for the tax implications of removing the owner’s salary from expenses which means removing the associated payroll tax as well.
Depreciation/Amortization - Depreciation and amortization are non-cash expenses meaning that these expenses will not affect the income received by the owner. In addition, when a buyer purchases the assets, they will then have a different depreciation schedule.
Interest - A buyer will most likely have a different debt structure and thus a different interest payment.
Health, Life, & Auto Insurance - Any personal insurance is always added back into SDE. However, any employee benefit insurance is not.
Personal Purchases - Many owners will buy a personal car through the business. If the car is not used for business and will not transfer with the business, it can be added back.
Phone Bill - Owners can add back the portion of the phone bill that is associated with their personal plan if it is being run through the business.
Charitable Contributions - Charitable contributions are always added back as long as you receive no benefit from them. If you donate to a charity and the head of the charity is a customer of yours, a buyer will be wary of this add-back.
Retirement Plan Contributions - If a business offers an IRA or 401k plan, you may add back the portion that was contributed to the owner's retirement account.
Payment to Family Members - To decrease tax liability, many businesses will pay a spouse or child a salary despite that family member not actually doing work for the business. In that case, you can add back their salary.
One-Time Expenses - Maybe you had to pay $50,000 last year for a machine that will last 20 years. That shouldn't count against your earnings because a buyer won’t have to make the same expense anytime soon. Or perhaps your company won a lawsuit and earned an extra $25,000 for the suit. A buyer will likely not have that occur and thus won’t view that as value to the business.
The goal of SDE is to paint an accurate picture of what a future buyer would earn from the business.
Sometimes this means that they would have to incur additional expenses than you do today.
This is common in businesses run by a husband and wife.
If both owners work full-time in the business and are retiring, a new owner will likely have to hire a replacement employee.
The salary of that employee would need to be subtracted from the total SDE.
Taxes as an Add-Back:
There is also the question about taxes. Depending on the broker, some will add taxes back in and others won’t.
I personally do not recommend it.
In my experience, adding taxes into SDE will boost the value of the company on paper, but an educated buyer will not pay for that additional value.
In the end of the day, taxes need to be paid and a buyer will not see that value transferred to them. Therefore, the price is normally negotiated lower if taxes are included in SDE.
Some businesses tend to be more cash businesses and not all of that cash ends up on the tax returns.
So do you add that money into SDE?
Well there are normally 2 people that you need to sell the deal to:
The business buyer
A buyer might be comfortable believing the amount of cash that is in the business and include that value in the purchase price (though typically that money will be valued at a lower multiple).
But a bank will not include that money in the value.
If the numbers aren’t on the tax return, the bank will not include it in any calculations or considerations.
My advice: if you have a large amount of cash in your business that goes unreported, start reporting it years before you decide to sell so that a bank and buyer will believe the owner earnings number you calculate.
3. SDE Example
Below is an example P&L with common add-backs.
I’ve included typical, circumstantial, and negative add backs so that this example will help you determine add-backs relevant to your business.
If you have difficulty identifying your add-backs, feel free to reach out. I’d be happy to help.
Bad debt over the last 5 years averaged $14,000/year.
Given to an unrelated charity. Discretionary expense.
Non-cash expense. A new owner may have a different depreciation schedule.
$12,000 of insurance expenses went towards the owner’s personal health insurance.
Interest expense. A new owner may have a different financial debt structure.
Need to hire a new manager as the owner’s spouse currently acts as the general manager.
Payroll taxes associated with the owner’s salary.
$900 of phone bill expense was for the owner’s personal phone.
Determining SDE can be complicated depending on the business and its accounting.
I advise all business owners to speak with an experienced broker when determining this number as it is the foundation determining your selling price.
Too low and you leave money on the table…
Too high and you won’t have any interested buyers.
Once you’ve accurately calculated SDE, you’ll need to establish your Seller’s Discretionary Earnings multiple. This is the last part of determining your business’s fair market value.