A common metric used to value small businesses is seller’s discretionary earnings, often abbreviated as SDE. This metric is a calculation of how much cashflow a business generates. The reason that SDE has become so common in the business brokerage industry is because it offers a standardized measure to compare small businesses, especially when they are owned and operated by different individuals.
The Importance of Cashflow
Before we dive into how seller’s discretionary earnings is calculated, it makes sense to take a moment to discuss the importance of cashflow in selling a business. The two most common ways an owner exits her business are selling off the assets (e.g. liquidation) and selling the business as a going concern.
Selling off assets is exactly what it sounds like: selling off inventory, equipment, etc. In this case, the business’s ability to generate cashflow has no bearing on how much a Turbo Air commercial freezer sells for.
On the other hand, some businesses sell as a going concern. This means that someone buys the business because of its ability (now or in the future) to generate cashflow. They’re looking at the business as an income stream, either as a hands-on owner-operator or as an investor.
When thinking about the business as a stream of cashflows, it’s important to be able to compare businesses. This will enable buyers to understand relative performance between two businesses. This will enable brokers to better set the asking price for the business. In these instances, seller’s discretionary earnings is a crucial method to compare the cashflows of businesses.
Big Business vs. Small Business
One reason that many people are confused by seller’s discretionary earnings is that it’s not a metric you’ll see associated with any large company. Off of main street, businesses will commonly report their EBITDA (earnings before interest, taxes, debt, and amortization).
Well, why don’t small businesses use EBITDA as well?
The reason that main street businesses do not use EBITDA is because small business owners approach their businesses’ expenses in varying and discretionary ways.
For instance, let’s assume we have Owner A and Owner B. Both of them own small businesses that generate $150,000 in earnings on any given year. Owner A, however, generally puts his family’s phone bill, vacations and health insurance on the company’s account. After his expenses, he generally sees about $115,000 in EBITDA. Owner B, on the other hand, likes to keep his personal and business expenses separate. He’ll simply pay out the earnings to his personal bank account and expense any such items on his personal credit card. So, he keeps seeing around $150,000 in EBITDA.
If you were to compare the two businesses with EBITDA, Owner B would seem to have a much better operation. In fact, his EBITDA is 30% higher than Owner A’s.
But in reality, the two businesses have the same profitability. They both generate around $150,000 in earnings. The difference is how the owners treat their businesses.
A similar example can be found with one-time expenses. If Owner A decides to invest in a new POS for his restaurant, his EBITDA could take a $70,000 hit on that year. Yet, when comparing to Owner B, they still own businesses that have roughly the same profitability.
Generally speaking, the larger the business, the less variable and the more separated the bookkeeping is. As such, you’d never find personal expenses from a Fortune 5000 owner on the company’s income statement. Or, if you did, they’d be in hot water. Because of this, people can use EBITDA to compare larger businesses without worrying too much about discretionary or one-off expenses.
On the other hand, the smaller the business, the more variable and the less uniform the bookkeeping is. So, in order to compare two businesses, the standard is Seller’s Discretionary Earnings. How a business owner decides to use the discretionary earnings shouldn’t affect how much the earnings total.
Calculating Seller’s Discretionary Earnings
The process for calculating SDE consists of calculating EBITDA and then performing add-backs to total the seller’s discretionary earnings. This process is called recasting, or normalizing, the financial statements. In the process of recasting the statements, a number of add-backs will be totaled. An add-back is simply a one-off discretionary expense or revenue, although there are a number of different types. Most of them add to the EBITDA and, thus, increase the seller’s discretionary earnings. Below are some of the most common.
Standard for Main Street
- Salary for the full-time owner-operator
- Payroll taxes
- Personal phone bills
- Personal health insurance
- Personal fuel
- Family vacations
Non-recurring Expenses or Revenues
- Legal expenses
- One-time technology upgrades
- Deposits of personal cash (e.g. this is an example of an add-back that would decrease SDE)
- Coaching fees
Hopefully this post has given you a better sense of what seller’s discretionary earnings means, why it’s used on main street, and how to calculate it. If you want help valuing your own business, please reach out for a free valuation.