Seller’s Discretionary Earnings, or SDE, plays a vital role in business valuation, especially in small businesses. In this guide, we will unravel the key aspects of SDE, its calculation, importance, and how it can be considered in evaluating the worth of a business.
What is SDE?
SDE is a measure of profit that indicates how much money the owner takes home at the end of the year. It’s akin to other profit measures like EBITDA or cash flow but has distinct characteristics and applications.
How SDE Works
The objective of SDE is to understand how much money a prospective buyer would earn if they were to buy and operate the business. Here’s how it works:
- Start with the Net Profit: This can be obtained from a tax return or a profit and loss statement.
- Add Back Certain Items: Including depreciation, interest, and the owner’s salary.
- Adjust for Non-cash Expenses: Such as tax-related items like depreciation and amortization.
- Account for Financing Related Expenses: Interest is typically added back as a new owner will have their loans and financial arrangements.
- Consider Discretionary Items: These may include the owner’s salary, family trips, personal vehicle leases, etc.
An SDE calculation might look like this:
- Net Income: From tax returns or P&L statement.
- Add Back: Depreciation, interest, owner salary, discretionary benefits (e.g., personal vehicle lease, family vacations).
- Result: Seller’s Discretionary Earnings.
Key Points in SDE Calculation
Common Add Backs
- Owner Salary: If the owner is working full-time in the business, their salary is typically added back.
- Depreciation: Added back as it’s a non-cash expense.
- Interest: Added back as it may vary with different ownership.
Differentiating SDE from Other Metrics
SDE includes the addition of the seller’s discretionary items, which sets it apart from metrics like cash flow or EBITDA.
Considerations for One-Time Adjustments
Sometimes, unique one-time occurrences in a business might require adjustments. For example, if a significant customer goes bankrupt, and it’s a rare event, that loss can be added back.
Why SDE Matters in Business Valuation
- Uniform Comparison: Allows comparison between businesses and owners irrespective of where the money comes from.
- Reflects Real Earnings: By including items that may not leave the owner’s bank account, it offers a realistic view of earnings.
- Tailors to Small Business Needs: Specific to small businesses where owners may have personalized expenses run through the business.
- Mid Street Website: For more detailed information and examples on SDE, refer to the mid street website at midstreet.com/sde.
Understanding what is SDE in business valuation is crucial for both sellers and buyers. It offers a transparent view of the earnings and allows for a more accurate assessment of a business’s value. By considering all factors, from owner salaries to one-time events, SDE provides a realistic and adaptable measure for small business valuation.