What is SDE and why is it important?

Seller’s Discretionary Earnings (SDE) is a measure of cash flow for a business.  It is used as a basis for valuations and to identify business opportunities within ranges for buyers.

Components of SDE
  1. We start with the net income before taxes.
  2. Add-backs
    1. Interest expense
    2. Depreciation expense
    3. One owner’s salary
    4. Some owners’ expenses run through the company.  Some examples may be life insurance paid by the company for the owner, auto expenses (if this is not necessary in the operations of the business), other identifiable expenses that would not be required by the buyer.  This becomes a murky area.  The main criteria is if the buyer’s bank would allow the adjustments, or not.
    5. e.    Unusual, one-time expenses. An example might be the deductible paid by the business for flood damage.
  3. Negative add-backs (deductions)
    1. Rent adjustments.  This often applies when the seller owns the property.  A positive or negative adjustment is applied for the variance in the amount paid and the fair market rent.
    2. Salary adjustment.  If there are two owners, you are only allowed to add-back one salary.  Say the second owner draws a salary of $20,000 and does the books.  We further assume it would cost $50,000 a year to replace them.  So, we would do a deduction of $30,000 for a replacement for Owner #2.  
    3. Other adjustments may apply such as a deduction for the gain on sale of an asset.  This would typically not be a part of the normal operations of the business, so it would be deducted.  
The net income before taxes, plus or minus the adjustments, equals the Seller’s Discretionary Earnings (SDE).

Buyer’s Perspective
SDE is the amount that is available to:
    Cover debt payments
    Pay yourself a salary
    Provide a reasonable financial return for taking on the risk of owning the business

Seller’s Perspective
SDE is the amount of cash flow that is applied to a multiple to calculate the value of the company.  It is in the seller’s interest to have the most SDE possible.  However, the add-backs need to be limited to only those that would be allowed by a bank.

Banker’s Perspective
Ultimately, the acquisition will be funded by a bank.  SDE is calculated separately by the bank’s underwriting department.  It is used in their calculations to see if there is sufficient cash-flow by which to service the debt.  This calculation is called the Debt Service Coverage Ration (DSCR).  And it is used in their independent valuation process.

Accurate SDE calculations are critical for successful business sales.  SDE’s that are inflated with invalid add-backs, lead to unrealistic valuation expectations for sellers, resulting in extended negotiations, or deal failures.  Accurate ones lead to quicker sales and better outcomes for both the sellers and the buyers.
 
Go Back