If you’re a business owner considering selling, you’ve probably encountered the term “seller’s discretionary earnings” (SDE). You may wonder what it means, how it impacts your business’s value and why buyers and business brokers pay attention to it. Discretionary earnings provide an accurate picture of a company’s profitability by accounting for expenses that may not directly impact its operations.
Discretionary earnings, or SDE, is a financial metric used in business valuation. It represents the total earnings of a business available to its owner before interest, tax, depreciation and amortization are accounted for. SDE provides a picture of a business’s profitability from the perspective of its owner, allowing buyers to assess a company’s financial health and earning potential.
When it comes to valuing a business or understanding its profitability, two financial metrics typically come up in conversation — SDE and “earnings before interest, taxes, depreciation and amortization” (EBITDA). Both are used to assess a company’s financial health, but some nuances exist.
SDE is most commonly used when selling small- to medium-sized businesses. It’s an attractive metric for buyers and sellers because it provides a straightforward view of what an owner can expect from the business.
EBITDA focuses on the company’s core operational performance and profitability without considering the impact of interest, tax, depreciation and amortization. EBITDA is commonly used for larger businesses or those in industries where capital expenditures and financing costs are significant.
Discretionary earnings have several elements that reflect a business’s true earning potential. These components help business owners accurately calculate SDE and use it for valuation or performance improvements.
Nonrecurring expenses are one-time costs that are not expected to happen again in the normal course of business. These might include legal fees from a lawsuit or costs associated with a one-time business expansion. Since nonrecurring expenses are not part of the business’s day-to-day operations, they are typically added back into discretionary earnings.
These are the total financial benefits the business owner receives through their company. Examples include compensation, such as salary, retirement contributions, and expenses that are paid via the business but the owner uses personally, such as health insurance.
Depreciation and amortization, or non-cash expenses, are accounting methods used to spread the cost of tangible and intangible assets. While depreciation and amortization can reduce a business’s taxable income, they do not involve an actual cash outlay. When calculating discretionary earnings, depreciation and amortization are added back — the money spent on these items does not directly impact the business’s cash flow, so they do not affect the owner’s ability to draw income from the business.
Owner’s compensation refers to the salary and bonuses paid to the business owner. When determining SDE, any portion of the owner’s salary that is deemed excessive or above-market is typically added back into the earnings.
This is because it represents money the owner is taking out of the business but would not be a necessary cost if the business were under new ownership. The new owner might not need to pay themselves the same amount, so it is considered an adjustment.
Interest is a legitimate expense, but it is often excluded when calculating discretionary earnings because it could change under new ownership. If a business has debt, the new owner might restructure financing, which could alter the amount of interest paid. As a result, interest expenses are added back into discretionary earnings to give a clearer picture of the business’s cash flow independent of its current financing arrangements.
When a business is up for sale, one aspect of the transaction is agreeing on its value. Because discretionary earnings involve adjustments, it is not uncommon for the seller and buyer to have differing opinions about what should be included or excluded in the final calculation. Below are common areas where disagreements arise between both parties.
Sellers may be inclined to exclude expenses like legal fees from the calculation, arguing that they are irregular and not indicative of the business’s ongoing operational costs. However, buyers may view these costs differently. They may be skeptical of the seller’s claims and want to conduct a thorough analysis to check if these expenses are truly one-time events. Buyers may insist on factoring in some of these costs into the final price to protect themselves from potential surprises after the sale.
Sellers may argue that their salary or bonuses reflect the value they bring to the business, including their leadership, decision-making and operational involvement. Buyers may see the owner’s compensation as artificially inflated, especially if it exceeds what would be reasonable for a new owner to pay themselves.
Discretionary earnings go beyond the basic concept of profit — they reflect the income available to the owner after considering all necessary business expenses. This gives the buyer and seller a clear understanding of what the business can truly provide to the owner. Overall, business SDE matters as a metric for the following reasons:
SDE offers a direct insight into what the business can provide to the owner. It represents the income the owner can take home after covering all necessary business expenses. This is especially important for retiring business owners. When preparing to sell, they need to know exactly what they can expect. Calculating discretionary earnings helps them make sound decisions and adequately prepare for their financial future post-sales.
Buyers are interested in the business’s historical performance and what it can generate for them after the acquisition. SDE allows buyers to see the business’s potential and determine if it aligns with their financial goals. For the seller, understanding their business’s discretionary earnings makes it easier for them to set a fair price that reflects the true financial value of the company.
Eliminating the noise created by extraneous costs may reveal how efficiently the business runs daily. This makes it easier to spot areas for improvement and opportunities to reduce expenses that might affect profitability. For a potential buyer, a business with high discretionary earnings signals the business is well-managed and can generate a solid return with minimal interference. For the seller, knowing their discretionary earnings are strong can provide peace of mind and confidence in the selling process.
For a buyer, discretionary earnings show the financial flexibility they would have once the business is in their hands. It indicates how much flexibility they will have to reinvest into the business, pay off debts or take personal income. This is especially valuable for those new to owning a business. They can plan for their financial commitments more effectively so the business meets operational and personal financial needs.
A strong discretionary earnings figure can give the owner confidence their business can be sold for a good price, which could fund their retirement or allow them to pass the company on to their family members or another party with a fair succession plan.
It also helps owners who plan to gradually transition into retirement. If they are shifting from full-time involvement to a less hands-on role, SDE shows them how much income they could expect during that transition period.
Knowing how much SDE a company generates is a valuable tool for making strategic decisions regarding growth. When owners or management teams understand the business’s profitability after all expenses, deciding how to reinvest those earnings for expansion becomes easier. For example, if discretionary earnings are high, it may be a good time to invest in scaling operations, entering new markets or hiring additional staff. Conversely, if discretionary earnings are low, it might be necessary to focus on streamlining processes or cutting costs before pursuing growth.
Focusing on the actual earnings that are available to the owner helps eliminate ambiguity and subjectivity that can arise in business valuations. They allow buyers to see the true profitability of a business, free from the potential distortions caused by owner-specific decisions or one-time accounting adjustments. For sellers, being transparent about discretionary earnings helps build trust with potential buyers.
Calculating SDE is a straightforward process that involves adjusting the net income by adding back expenses that are considered nonessential to the main operation of the business. The basic formula is:
SDE = Net Profit + Owner’s Salary + Owner’s Benefits + Nonrecurring Expenses + Depreciation + Amortization + Interest Expenses + Taxes
Let’s walk through an example of calculating SDE using a fictional business, ABC123 Manufacturing.
Suppose ABC123 Manufacturing has the following financial data:
Using the discretionary earnings formula, we get the following figures:
In this example, ABC123 Manufacturing’s SDE is $385,000, which means the total discretionary earnings available to a new owner are $385,000.
Once SDE is calculated, it can be used to estimate a business’s valuation. Buyers and business brokers apply an SDE multiple to determine the fair market value of a business. For example, if ABC123 Manufacturing’s SDE is $385,000 and the industry typically applies a three-times multiple, then the business’s estimated values are Business Value = SDE x Multiple, which translates to:
Thus, the business would be valued at approximately $1.16 million in a potential sale.
Improving SDE can boost a business’s value, especially if the owner plans to sell. This can make a company more attractive to potential buyers and may give business owners leverage to command a higher selling price.
Increasing revenue is one of the most straightforward and effective ways to improve business SDE. More income means more profits, ultimately leading to higher earnings available to the owner. Here are some strategies for growing your business’s revenue:
If increasing revenue poses a challenge, business owners can reduce nonessential costs to boost SDE. Lowering expenses can improve profitability and maximize the amount of discretionary earnings available for the owner. Business owners can reduce expenses in the following ways:
At Synergy Business Brokers, we specialize in helping business owners value and sell their companies. Our approach is professional, confidential and results-driven. We speak the language of buyers and investors to present your business in the best light. There are no upfront costs — you only pay us if we successfully sell your enterprise. Contact us today for a confidential valuation.
