As a small business owner, it’s important to receive regular valuations of your business. These business valuations not only help you avoid future valuation gaps, but they also identify weaknesses in your company that need addressing. The feedback you get during a valuation can prove tremendously valuable when you’re looking to sell.
There are different methodologies that your team of advisors will use to evaluate your company. One such example is “seller’s discretionary earnings” (SDE), which is an earnings metric used to help determine the value of an organization.
Knowing what seller’s discretionary earnings are, how and when the metric is used, and how the metric compares to other similar options can help you better understand the business valuation that you receive. In this guide, you’ll gain a high-level overview of seller’s discretionary earnings and how they can impact your business, especially when you’re looking to sell.
What Are Seller’s Discretionary Earnings?
Seller’s discretionary earnings is a metric that helps advisors perform business valuations and more accurately portray profitability from valuations. Specifically, SDE is almost always used for small businesses who are owner-operated. An owner-operator is essentially an employee with a business attached to their name. While the business may be structured as a pass-through entity — usually an LLC or S Corp — it’s questionable whether it could exist without the owner.
SDE calculations are necessary because owner-operators tend to “live out of their business” and may blur the line between business and personal expenses. This is perhaps one reason why SDE is also referred to as the “total owner’s benefit” metric. SDE makes adjustments to reflect cash flow, including all forms of owner’s compensation as well as some operating expenses. The types of expenses that can be adjusted include:
- Discretionary expenses: These are expenses that a business can survive without, such as personal meals and entertainment, mobile phone services, and auto expenses.
- Non-recurring expenses or one-time expenses: Expenses that are not monthly, annual, or recurring. An example would be the purchase of software that is good for a lifetime.
- Extraordinary expenses: An expense that comes from an unusual event, such as a natural disaster or accident.
- Interest expenses: These are the costs associated with borrowing money from lenders.
Also taken into consideration are pre-tax profits. By factoring in profit before tax, as well as adjusting for the above expenses, business brokers can better determine the value of an organization based on its cash flow.
By doing this, business brokers and advisors can isolate genuine operating expenses, painting an accurate picture of the true earnings of a business.
When and How Are Seller’s Discretionary Earnings Used?
Seller’s discretionary earnings is not a commonly used metric outside of the sale of a business. In fact, its use is quite limited. It may only be used to determine the value of your business if you’re a small business with annual sales less than $2 million. It isn’t used much for larger small businesses, such as those operating in the lower middle market (those with revenues between $5 million and $25 million).
As mentioned, SDE is often used with owner-operated businesses. However — regardless of the size of the business or entity structure — the extent to which the owner is influencing expenses must be determined. It will have an impact on the value of the business, and may even determine the types of buyers who may or may not be interested in acquiring the business.
To take this one step further, business brokers may only use this metric if the business is going to be purchased by another owner-operator. It would be used only when the current company is run by an owner-operator and the new owner intends to run it the same way.
It’s worth stressing that measuring seller’s discretionary cash flow can be a subjective process. If you’re selling your business, and both the buyer and the seller are using SDE, there’s a strong chance that there will be disagreements.
Buyers want a lower sale price to maximize their return on investment. They may push back on certain things, such as one-time expenses. For instance, if the previous owner purchased a five-year software membership — is this a one-time expense? The seller may say so. Or is it a recurring expense? The buyer may say so.
Having a team of trusted advisors and brokers can help you navigate these muddier waters and put you in the position for success when selling your company.
How Are Seller’s Discretionary Earnings Different From Adjusted EBITDA?
When reading about seller’s discretionary earnings, one of the first things that may come to mind is “earnings before interest, taxes, depreciation, amortization,” more commonly known as EBITDA.
Depending on the valuation method, business brokers and advisors may use Adjusted EBITDA to measure the value of a company. Adjusted EBITDA is often used to properly value businesses in the lower middle market, but that does not mean it won’t be used during owner-operated SDE valuations as well.
To better understand how Adjusted EBITDA relates to SDE, first take a look at the breakdown of EBITDA components:
- Earnings: Often referred to as Net Income, this is the amount of profit remaining after subtracting your operating expenses and costs of goods sold.
- Interest: Financing costs that are associated with business debts.
- Taxes: State and federal income taxes for your business.
- Depreciation: Considered a non-cash expense, depreciation is used to calculate the cost of a tangible asset over its useful life.
- Amortization: This is similar to depreciation, except it refers specifically to intangible assets and loans. Examples of intangible assets include intellectual property and Goodwill.
All of these components are included in SDE when your broker is looking through your financial statements and determining your pre-tax income. In fact, normalizing EBITDA entails many of the same steps as an SDE calculation.
SDE merely takes this process one step further, as it adjusts for perks that business owners may have been receiving as they attempted to lower their taxable net income. You’ll find that there may be more add-backs when calculating SDE, although there is a limit to what buyers will accept.
These add-backs are again taken based on what you and the other party are looking to get out of the process. Buyers will not just accept all add-backs, as they are trying to get a true picture of the cash flow that will be available to them and not overpay.
Sellers, on the other hand, are more apt to include add-backs as it shows that the business is worth more than its net profit currently indicates. As an example, a seller may claim that they used business funds for personal travel. As such, they will try to claim this as non-operating income to prove that the direct business cash flow of the company is higher than it appears.
This again demonstrates why it’s so important to have a broker you can trust when representing the sale of your company to sophisticated buyers.
Take Time to Understand Key Concepts During the M&A Process
As a business owner, it’s important for you to understand the true market value of your business. Doing so allows you to make strategic decisions based on your long-term goals.
If you’re a smaller business, one of the terms that may come up during a valuation is seller’s discretionary earnings. SDE is a metric that adjusts for any personal financial benefits you’re gaining as a result of owning and operating your business, reflecting only legitimate cash flow.
The good news is that whether you’re interested in selling your company in the next few months or the next few years, you can count on the team of brokers at Allan Taylor & Co. With more than 15 years of experience helping owners in the lower middle market, we can help you reach your long-term business goals.