Seller’s discretionary earnings (SDE) are calculated by your broker or advisor during a business valuation. It represents how much your company earned before the owner takes a profit and deducts recurring and non-recurring expenses. This guide defines SDE, explains its importance, and highlights how a business broker calculates your SDE during a business valuation.
Seller’s Discretionary Earnings (SDE) Explained
Seller’s discretionary earnings, or SDE, is a financial metric that shows the full business earnings for an owner-operator. SDE begins with your net profit and then adds back recurring and non-recurring expenses.
SDE is similar to your earnings before interest, taxes, depreciation, and amortization (EBITDA) but with one major difference. SDE adds back your owner’s compensation — EBITDA does not. This allows potential buyers to see the full business potential before the owner’s salary deduction. The example below highlights the importance of SDE for owner-operator businesses:
EBITDA is $750,000
Owner-operator’s annual salary is $250,000
SDE is $1 million
EBITDA is $750,000
Owner-operator’s annual salary is $100,000
SDE is $850,000
In the above example, Company A’s SDE is $1 million. Company B’s SDE is $850,000.
This means that despite having the same EBITDA, the SDE between the two companies is far apart. For this reason, small to mid-sized businesses are often best suited using SDE multiples as opposed to an EBITDA multiple (which is ideal for large companies where the owner takes more of an investor role than an operator).
How a Business Broker Calculates Your Seller’s Discretionary Earnings (SDE)
Your business broker first determines your pre-tax income.
They will then add back costs associated with interest, depreciation, and amortization. This financial figure is known as your earnings before interest, taxes, depreciation, and amortization (EBITDA).
The business broker then adds back all recurring and non-recurring (one-time) costs to your EBITDA figure (see add-backs below). This produces your SDE, which plays a pivotal role in determining the fair market business value for your company.
Financial Considerations for an SDE Calculation
As mentioned, your business broker will first calculate your pre-tax income. They must also calculate your tax expenditure, owner’s compensation, net interest expense, depreciation deductions, and amortization. These values are derived from your company’s financial documents. During the valuation, you may be asked to provide your:
- Federal tax returns (3+ years)
- Profit and loss (P&L) reports
- Balance sheets
- Customer lists (with the percentage of revenue for each customer)
For example, if you are receiving a business valuation for an appliance service company (or another home improvement or service repair business type), then you will need to provide your percentage of new construction, retrofit, and service. Your business broker may also need your percentage of residential and commercial revenue.
The Different Types of Owner Add-Backs Used for SDE Calculation
The two primary types of owner add-backs used for SDE are recurring and non-recurring add-backs. Recurring add-backs include your standard and discretionary expenses. Discretionary expenses are add-backs that are not expected to continue with the new owner. Below is a breakdown of the primary add-back types.
Owner’s compensation is the primary add-back during an SDE calculation. This is the amount that you pay yourself annually as the company’s owner. However, there are additional add-backs. Specifically, SDE adds back all recurring (continual) expenses. Other recurring add-backs include:
- Family member compensation – If other family members are compensated, then their salaries are also added back.
- Family insurance policies – This can include (but is not limited to) auto, property, health, and life insurance.
- Travel, meal, and entertainment expenses – This should be added back if the expense was not entirely business related
- Club expenses (i.e. golf and country club) – Club dues and expenses are discretionary and will not transition to the new owner. Therefore, they should be added back.
- Family phone expenses – Any personal or family phone plans that are not carried over to the buyer are added back.
- Charitable donations – This could also be considered non-recurring, depending on the context.
Non-recurring add-backs are (most often) one-time expenses. They are not expected to be necessary expenditures for the new owner. Non-recurring add-backs your business broker may identify include:
- Revenue items – These are expenses with a short-term impact on the business. For example, this may include costs to repair your service trucks.
- PPP loans – This, along with similar government loans, are also included as non-recurring add-backs.
- Sale of asset – If you have purchased any tangible or intangible assets, then these should be added back.
- Expense items – Any one-time expense items are added back. This is separate from recurring business expenses such as rent, utilities, wages, etc.
- Loss on insurance claim (non-reimbursed) – If you filed an insurance claim that was denied, then you should add back the non-reimbursed expenditure
- Major repair, improvement, or purchase – This includes any one-time repair or improvement for business purposes
- Major legal, accounting, or consulting expense – For example, any legal fees associated with prior lawsuits are not expected costs for the buyer
- Major one-time marketing costs (i.e. website design) – Any major costs for marketing that are not ongoing are added back.
Who Needs an SDE Calculation?
Any owner-operator business needs an SDE calculation, particularly business owners who are planning their exit strategy. With that said, SDE is also beneficial for business owners who are not ready to sell as it helps them make better decisions in regard to business growth.
Keep in mind, SDE is recommended for small to mid-sized businesses. Companies with $10 million in more in annual revenue may be better suited for an EBITDA calculation and multiple. Notably, industries and business types that typically require an SDE calculation include:
Contact Brentwood Growth for a
Complimentary Business Assessment
We are an experienced business brokerage that takes pride in helping business owners understand the full value of their company and receive full value during a business sale. We provide free, no-obligation business valuation services, which involve calculating your seller’s discretionary earnings (SDE).
Contact us today for more information and to receive your business valuation and assessment.