Definition of Seller's Discretionary Earnings
Seller’s Discretionary Earnings, or SDE, is a type of annual cash flow used to benchmark a privately owned small business profitability based on a single full-time owner operator. The net income is reconstructed to account for “discretionary expenses” which are typically owner benefits.
The purpose of this financial reconstruction, or income normalization, is to show the true economic earning potential of a small owner operated business.
A privately owned small business with few or single shareholders will commonly have owner “tax optimizations” where discretionary expenses are paid by the company for owner benefits. Expenses such as personal mobile phone plans, owner’s automobile leases and expenses, owner’s medical expenses and many others are paid by the company for the benefit of the owner.
Since these non-operating expenses are often run through the company expenses, we need to normalize the income in the tax returns or accountant prepared financial statements in order to remove any owner benefits. Once SDE is determined, we are then able to compare business A with business B and to be able to make a valuation analysis .
How Seller's Discretionary Earnings is Derived
The process of deriving SDE commonly include adjustments such as:
- One-time non-recurring expenses or single expense items that do not often repeat. For example, office moving costs.
- Add back depreciation and amortization back to income as these are no-cash expense. These are allowable tax deductions from previously purchased capital equipment.
- Add back one working owner’s wage that was paid in each year.
- Add back all other owner/family member wage.
- Mark to market salaries of owners and/or family members. If the other owner(s) were working in the business, we then deduct a market rate for the job they did from income (or add to expense). The reason we add back and then deduct a market rate is because often they are either paid too low or too high. Thus, the market cost of replacing the working owner is then added to expense.
- Add back to income any interest paid on any long-term debt.
- Inventory adjustments if any.
SDE vs EBITDA
There are no fixed rules of when to use SDE or EBITDA. The generally accepted rule is to use SDE for smaller businesses with less than $500,000 in earnings and where the owner is needed to work in the business.
EBITDA, a norm for larger M&A deals, is used for businesses where the business is owner absentee or is in a management role where a General Manager or CEO can be hired to take over.