Understanding Seller’s Discretionary Earnings
One way to measure the value of a business is to determine the seller’s discretionary earnings (SDE) or income. This is a cash-flow measurement of the business earnings. SDE is often used in business valuation and in the sale of small businesses.
A valuation expert determines SDE by starting with the company’s EBITDA and adding back potential expenses a new owner may not incur. Below we discuss why it is important to understand SDE and what potential expenses SDE may include.
Why is it important to understand SDE?
For buyers: SDE gives potential buyers a better picture of their expected return on investment. As such, the goal of SDE is to help the buyer gain a realistic understanding of the earnings of the business.
For sellers: If you are looking to sell your business, understanding SDE can help to maximize the value of the business. Through understanding these expenses and income, the seller can decide what to include in the sale and how to make their financials cleaner. The cleaner your financials are the more likely you are to sell for the best price and terms. It is also helpful when negotiating with potential buyers.
What does SDE Include?
To determine seller’s discretionary income, a valuation analyst considers several items. Some items will need adjustment to reflect the needs of a new owner and current market rates.
First, seller’s discretionary earnings begins with EBITDA or earnings before interest, taxes, depreciation, and amortization. This shows how much the company earnings. EBITDA also gives an investor an idea of the return on investment once they buy the business.
One-time or Non-recurring Expenses
Next, a valuation expert adjusts income for non-recurring items or one-time expenses. One-time expenses include items that are non-recurring and typically only paid once. Examples may include website design, business licenses, one-time application fees, legal fees, etc.
Non-related Business Income and Expenses
This includes income and expenses not directly related to core business activities. A few examples of non-related business income and expenses may include:
- Costs incurred by taking extra time on a business trip for personal vacation
- Fuel and automobile expenses for a business that does not require automobiles
- Consulting income not related to the business
- Charging your business “rent” for a home office
- Business owner’s personal health insurance
When determining the value of a business, the valuation analyst will consider some expenses that need adjustment to current market rates. For instance, suppose you own two businesses both located in the same space with the overlapping workforce. So, if you were to sell one of the businesses, the costs will need adjustment to account for the expenses needed to replace the workforce and pay rent. In addition, many business owners pay themselves what they need rather than at current market rates.
One Owner’s Benefit or Replacement Owner
For valuation purposes, in the standard calculation of SDE, only one owner’s benefit or salary can be added back to the earnings. As such, if there is more than one owner the value of the seller’s discretionary earnings may be overstated or understated.
As part of a business valuation, the analyst will project the replacement costs for replacing the other owner’s efforts and work. All owner’s benefits are adjusted to represent current market rates equal to what the new owner will pay a full-time employee to perform that function or the amount they will pay themselves.
Disagreements between Buyers and Sellers
When a valuation expert determines SDE, it is likely the seller and buyer will disagree on some of the income, expenses, and replacement costs that are included. For instance, some one-time expenses may reoccur in the future such as updates to the website. With all valuations, this is a bit of an art and understanding of how businesses have operated in the past. As such, it is not uncommon for a buyer and seller to disagree about what the valuation expert includes or not includes in the discretionary earnings.
The goal of identifying seller’s discretionary earnings is to determine what a new owner can reasonably expect in annual earnings. SDE and SDE multiples are most common when valuing smaller companies. Whereas EBITDA multiples are more common when valuing large companies.
A business appraisal can help both a buyer and a seller gain a realistic picture of the business and its earnings. Peak Business Valuation, business appraiser Utah, enjoys working with individuals looking to buy or sell a business. Questions are always welcome! Please reach out via email or by scheduling your free consultation!
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