As a business owner, you’ve likely heard of seller’s discretionary earnings (SDE). But do you know what it is, how it’s calculated, and how it can impact the value of your business?
In this post, we’ll explore SDE in-depth, and provide insights that will help you understand how to use it to your advantage when selling your business.
Let’s get started.
What is seller’s discretionary earnings?
Seller’s discretionary earnings (SDE) is a critical metric for business owners who are planning to sell their business.
SDE, also known as seller’s discretionary cash flow, is the pre-tax earnings of a business that are available to the owner, including salaries, perks, and non-recurring business expenses that are unlikely to continue after the business is sold.
In short, SDE represents the total financial benefit the owner of the business can reasonably expect to receive from the business each year.
Once you’ve calculated the SDE amount, you can use it as part of a business valuation process and determine what it could be worth in a sale.
How do you determine seller’s discretionary earnings?
To determine SDE, you need to start with the business’s net income and then add back any owner-specific expenses that are not necessary for the operation of the business.
To determine SDE, start with your business’s net income, and then add back any expenses that are specific to you as the owner. This might include things like your salary, bonuses, health insurance, car payments, and other personal expense that the new owner may not incur.
You should also add back any one-time expenses, such as legal or accounting fees associated with the sale of the business.
What could qualify as discretionary expenses?
When determining SDE, it’s important to understand which expenses can be considered discretionary and which are non-discretionary.
As I mentioned earlier, discretionary expenses are those that are specific to the owner and are not necessary for the operation of the business.
Some examples of owner-specific expenses that could qualify as discretionary expenses:
- Owner’s salary and benefits
- Personal expenses paid through the business (e.g., car, travel, personal meals – think things that result in a personal benefit)
- Depreciation and amortization expenses (non cash expenses)
- Interest expense and taxes paid by the business that are not necessary for the operation of the business
It’s important to call out that not all owner-specific expenses are necessarily discretionary. For example, if the owner of a consulting business is also the primary consultant, their salary and benefits would not be considered discretionary, as they are necessary for the operation of the business.
On the other hand, if the owner of a retail business takes a salary that is higher than what would be paid to an outside manager, the excess amount could be considered a discretionary expense.
It’s also worth noting that one-time expenses, such as the cost of relocating the business or a major marketing campaign, could also be considered discretionary expenses, as they are non recurring expenses necessary for the operation of the business.
Is SDE the same as profit?
SDE is not the same as profit, although the two terms are often used interchangeably. Profit is the amount of money that a business makes after all expenses, including taxes, have been paid. It’s a broader measure of a business’s financial performance and does not take into account the owner’s personal or other discretionary spending.
SDE, on the other hand, is the amount of money available to the owner of the business after all expenses have been paid.
While profit is certainly an important metric to consider when valuing a business, SDE is often a more accurate reflection of the true earnings potential of the business. By adding back owner-specific expenses and one-time expenses, SDE provides a clearer picture of how much money the new owner can expect to make from the business.
Sellers discretionary earnings vs net income
It’s important to note that SDE is not the same as net income on financial statements. While net income is a useful metric for understanding the overall profitability of a business, it doesn’t provide a complete picture of the earnings potential of the business.
SDE, on the other hand, takes into account owner-specific expenses and one-time expenses, which provides a more accurate reflection of the true earnings potential of the business. For this reason, SDE is often used as the basis for valuing a business.
How is SDE calculated?
As mentioned above, SDE is calculated by starting with the business’s net income and then adding back owner-specific expenses that are not necessary for the operation of the business.
Here’s a step-by-step breakdown of how to calculate SDE:
- Start with the business’s net income: Begin by calculating the business’s net income for the year. This is the revenue the business earned minus all of its expenses, such as salaries, rent, taxes, and other costs.
- Add back any owner’s salary or compensation: If the owner of the business takes a salary or other compensation, add it back to the net income. This adjusted cash flow amount is often called “owner’s salary” or “owner’s compensation.”
- Add back any personal expenses: If business paid for personal items of the owner, such as a car or phone, add these expenses back to the net income.
- Add back any other discretionary expenses: In addition to owner’s salary and personal expenses, there may be other expenses that the owner considers discretionary. These could include travel, entertainment, or other expenses that are not strictly necessary for the operation of the business. Add these expenses back to the net income as well.
- Subtract any non-discretionary expenses: Finally, subtract any non-discretionary expenses that the new owner would have to incur if they were to purchase the business. These expenses could include loan payments, rent, or other fixed costs that the new owner would need to pay.
The result of this calculation is the seller’s discretionary earnings (SDE). This represents the amount of cash flow available to the owner of the business, which can be used to pay for expenses and other obligations.
How do you value a company using SDE?
Valuing a company using SDE is a relatively simple process. First, you’ll determine the SDE for the business. Next, you’ll apply a multiple to that number to arrive at a valuation.
The multiple that you use will depend on a variety of factors, including the industry that the business is in, its growth potential, and the current market conditions.
What is a good SDE multiple?
As mentioned above, the multiple that you use to value your business will depend on a variety of factors.
As a general rule of thumb, businesses in most industries can be valued at between 2 and 4 times their SDE.
If your business has a high growth potential, a loyal customer base, and a strong competitive position in the market, you may be able to command a higher multiple.
On the other hand, if your business is in a declining industry or has limited growth potential, you may need to settle for a lower multiple. It’s also worth noting that larger businesses typically command lower multiples than smaller businesses, due to the reduced risk associated with larger businesses.
Ultimately, the multiple that you use to value your business should reflect a realistic assessment of the company’s future earnings potential, as well as the level of risk associated with owning the business.
Seller discretionary earnings example
To illustrate how SDE works in practice, let’s walk through an example.
John owns a small manufacturing business that has a net income of $200,000 per year. John is a full time owner operator and pays himself a salary of $80,000 per year, and drives a company car that costs $10,000 per year to operate. In addition, John has incurred $20,000 in legal fees associated with the sale of his business.
To calculate the SDE for John’s business, we would start with the net income of $200,000 and add back John’s salary, car expenses, and legal fees. This would give us an SDE of $310,000 ($200,000 + $80,000 + $10,000 + $20,000).
If we assume that John’s business can be valued at 3 times its SDE, then the business would be worth approximately $930,000 ($310,000 x 3).
Switching to professional management
Before we wrap up, I want to cover a strategy that can dramatically increase your valuation and potential exit price.
One way to increase your small business valuation multiple and company value is to swap out the current manager or owner for a professional manager. This has multiple advantages, such as helping your valuation and making your company more marketable. A company that is less reliant on the owner is typically seen as being more valuable, as there is less risk involved.
Professional buyers know that owners tend to leave their businesses after they sell them, rather than sticking around and helping. Ideally the owner’s exit from a business is of little or no consequence for its future cash flow and value…but if it cannot continue growing in value without your help, it’s a real turn-off to buyers.
Hiring professional management can help take some of the responsibility off of your shoulders and put it onto someone who is trained to handle such duties. Additionally, this will give the company a more professional appearance, which can attract investors.
Making the transition from an owner-run business to a management-run business can take time, but it can be transformational if you want to sell your business or attract outside investors.
Just by making this one change you’ll see a drastic increase in the EBITDA multiple you’ll be able tosell your businessat:
- Owner Operated: 2.5X
- Professional Management: 4.5X
This means the company is worth 2X more (on average, across all industries according to BVR Deal Stats).
Through transitioning to professional management we can instantly create multiple arbitrage and have more buyers that are willing to pay ahigher price.
Conclusion
Understanding seller’s discretionary earnings is essential for any business owner looking to sell their business. By accurately calculating SDE and using it to value your business, you can ensure that you receive a fair price for your hard work and investment.
Remember, the multiple you use to value your business will depend on a variety of factors, so it’s important to seek advice from an or business broker to help you arrive at a realistic valuation.
I hope you found this helpful, feel free to drop a comment if you have any questions.
FAQs
What does seller's discretionary earnings mean? ›
Seller's discretionary earnings (SDE) is a measure of the earnings of a business and is the most common measure of cash flow used to value a small business. SDE allows a buyer to quickly compare two companies for valuation purposes.
What is the formula for seller's discretionary earnings? ›SDE is typically the net income (or net loss) on the company tax return + interest expense + depreciation expense + amortization expense + the current owner's salary + owner perks.
What is an example of a seller's discretionary cash flow? ›Typical discretionary expenses are owner medical or life insurance, personal travel, personal automobiles, personal meals/entertainment, and social club memberships.
What are the multiples of seller's discretionary earnings? ›Multiples on seller's discretionary earnings are typically in the 2-3x range but can go as high as 4x if your company is nearing $1 million in SDE. If your earnings are between $1 million and $2 million, your business is likely to sell for 3-6x EBITDA depending.
Is seller's discretionary earnings the same as profit? ›Seller's discretionary earnings is a cash-flow based measure of business earnings in an owner-operated business. It comprises the profit before tax and interest of a business before the owner's benefits, non-cash expenses, extraordinary one-time investments, and other non-related business incomes and expenses.
What are 2 examples of discretionary income? ›Discretionary income is the amount of an individual's income that is left for spending, investing, or saving after paying taxes and paying for personal necessities, such as food, shelter, and clothing. Discretionary income includes money spent on luxury items, vacations, and nonessential goods and services.
How do you value a business based on SDE? ›- Net Income plus any expenses that are considered “add backs” (expenses the new owner likely won't have to spend this money on on an ongoing basis); or.
- Gross Profit minus any expenses that will be required to continue running the company to maintain its existing SDE.
The main difference is: SDE is the primary measure of cash flow used to value small businesses and includes the owner's compensation as an adjustment. EBITDA is the primary measure of cash flow used to value mid to large-sized businesses and does not include the owner's salary as an adjustment.
What is 10% discretionary income? ›Discretionary Income Percentage
For a simple example, let's say your annual discretionary income is $12,000 and you're on PAYE. That means 10% of your discretionary income would be your student loan repayment amount. $12,000 * 10% = $1,200 per year. So, your monthly payment would be $100.
SDC (Seller's Discretionary Cash), also known as SCD (Seller's Discretionary Cash Flow), is the total cash benefit or income the owner realizes from owning the practice. This is calculated by recasting the owner's financial statements and adding the owner's benefits to the profit of the business.
What is SDE multiple for every industry? ›
The Definition of an SDE Multiple
As we mentioned above, SDE means Seller's Discretionary Earnings. To find your business's SDE, a valuation specialist must find the earnings of your company before income tax, depreciation, amortization, interest, discretionary or recurring expenses, and one owner's salary.
SDE is Not Cash Flow.
Rather, it is the amount of potential earnings available to the business owner based on the company's normalized earnings and owner salary.
50% of your net income should go towards living expenses and essentials (Needs), 20% of your net income should go towards debt reduction and savings (Debt Reduction and Savings), and 30% of your net income should go towards discretionary spending (Wants).
What is discretionary income and who has the most discretionary income? ›Discretionary income is the money you have left over after paying taxes and necessary cost-of-living expenses—like your rent or mortgage, utilities and groceries. It's called “discretionary income” because it can be used for discretionary expenses—nice-to-haves but not necessities.
How do you value a business multiple of earnings? ›The multiple of earnings is a valuation method whereby the value of a company is expressed through the use of a multiple applied to the company's earnings. For example, a company that has earnings of $1 million dollars with a multiple of 6x will be valued at $6 million.
What is the difference between discretionary income? ›Conclusion. The term "disposable income" is used to describe the amount of money left over after taxes have been taken out of a person's or family's earnings. Discretionary income, on the other hand, is what's left after a person pays their taxes and their fixed costs like housing, food, and clothing.
How do you calculate owner benefit? ›The theory behind the Owner Benefit number is to take the business's profits plus the owner's salary and benefits and then to add back the non-cash expenses. History has shown that this methodology, while not bulletproof, is the most effective way to establish the valuation basis of a small business.
Is discretionary earnings the same as EBITDA? ›SDE stands for Seller's Discretionary Earnings, while EBITDA means Earnings Before Interest, Taxes, Depreciation, Amortization. These are calculations used to determine the value of a business. SDE measures the potential revenue of a business.
What are 5 examples of discretionary expenses? ›- Vacations and travel expenses.
- Automobiles.
- Alcohol and tobacco.
- Restaurants and other entertainment-related expenses.
- Coffee and specialty beverages.
- Hobby and sports-related expenses, such as crafting, sewing, and gym memberships.
According to a 2018 article in The Motley Fool, the average level of discretionary income for U.S. households was $20,748 per year, or $1,729 per month. According to a 2021 survey by The Balance, however, over half of Americans had $250 or less of discretionary income each month.
What is the best use of discretionary income? ›
On the contrary, your disposable income should be used to cover your cost of living and non-negotiable expenses. “Disposable income is used for living expenses and other necessities [such as your] mortgage or rent, transportation, health insurance, and food.
How do you value a company quickly? ›- Tally the value of assets. Add up the value of everything the business owns, including all equipment and inventory. ...
- Base it on revenue. How much does the business generate in annual sales? ...
- Use earnings multiples. ...
- Do a discounted cash-flow analysis. ...
- Go beyond financial formulas.
The formula is quite simple: business value equals assets minus liabilities. Your business assets include anything that has value that can be converted to cash, like real estate, equipment or inventory. Liabilities include business debts, like a commercial mortgage or bank loan taken out to purchase capital equipment.
How do you assign a value to a business? ›One way to value a business is to add the resale value of the assets and subtract liabilities. You can get accurate values for physical assets such as warehouses, office buildings, inventory and manufacturing facilities as well as real estate holdings.
What is the highest salary of SDE? ›SDE salary in India ranges between ₹ 3.5 Lakhs to ₹ 40.0 Lakhs with an average annual salary of ₹ 14.0 Lakhs. Salary estimates are based on 2.1k latest salaries received from SDEs.
What is the highest base salary of SDE? ›SDE (Software Development Engineer) salary in India ranges between ₹ 5.0 Lakhs to ₹ 50.0 Lakhs with an average annual salary of ₹ 15.0 Lakhs.
Which company pays the highest for SDE 1? ›- Microsoft Corporation Sde1 Salary - ₹39.2 Lakhs per year.
- Google Sde1 Salary - ₹37.4 Lakhs per year.
- Amazon Sde1 Salary - ₹29.6 Lakhs per year.
- Adobe Sde1 Salary - ₹29.3 Lakhs per year.
Disposable income is net income. It's the amount left over after taxes. Discretionary income is the amount of net income remaining after all necessities are covered. Economists monitor these numbers at a macro level to see how consumers save, spend, and borrow.
What does discretionary income level mean? ›What is a Discretionary Income? Discretionary income is the amount of money left for an individual to spend or save after paying taxes and for personal needs, such as food, lodging, and clothes. Discretionary income includes money spent on luxury goods, holidays, and non-essential goods and services.
Which group has the most discretionary income? ›Not only are Baby Boomers the wealthiest generation, holding 70% of the disposable income in the U.S. and spending over $548 billion a year, but they also they spend more than any other generation, across all categories.
What is discretionary cash flow? ›
What Is Discretionary Cash Flow? Discretionary cash flow is the money left over once all capital projects with positive net present values have been funded and required payments have been made.
What is SDC expenses? ›They are expenses incurred whilst travelling from home to a permanent (as defined by the legislation) place of work. They also include expenses incurred as a result of the journey e.g. subsistence and accommodation. SDC.
What is an annual SDC? ›SDC Annual Accounting Report
An SDC is a one-time fee imposed on new or some types of re-development at the time of development.
The exact value of a business with $1 million in sales would depend on the profitability of the business and its assets. Generally, a business is worth anywhere from one to five times its annual sales. So, in this case, the business would be worth between $1 million and $5 million.
What is a good EBITDA for a small business? ›EBITDA margin = EBITDA / Total Revenue
The EBITDA margin calculated using this equation shows the cash profit a business makes in a year. The margin can then be compared with another similar business in the same industry. An EBITDA margin of 10% or more is considered good.
An EBITDA over 10 is considered good. Over the last several years, the EBITDA has ranged between 11 and 14 for the S&P 500. You may also look at other businesses in your industry and their reported EBITDA as a way to see how your company is measuring up.
Is cash flow better than earnings? ›There are a couple of reasons why cash flows are a better indicator of a company's financial health. Profit figures are easier to manipulate because they include non-cash line items such as depreciation ex- penses or goodwill write-offs.
What are the three types of cash flow for a company? ›There are three cash flow types that companies should track and analyze to determine the liquidity and solvency of the business: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. All three are included on a company's cash flow statement.
How do you use EBITDA to value a company? ›To employ EBITDA to value a business, look at other organizations in the same industry that have sold recently, and compare their selling prices to their EBITDA information. This yields a multiple of selling prices to EBITDA that can be used to arrive at a general estimate of what a company is worth.
What does discretionary mean in real estate? ›The term "discretionary" refers to the fact that investment decisions are made at the portfolio manager's discretion. This means that the client must have the utmost trust in the investment manager's capabilities.
What is a good amount of discretionary income? ›
50% of your net income should go towards living expenses and essentials (Needs), 20% of your net income should go towards debt reduction and savings (Debt Reduction and Savings), and 30% of your net income should go towards discretionary spending (Wants).
What is considered my discretionary income? ›Pertaining to the Income-Contingent Repayment Plan, discretionary income is the difference between your annual income and 100 percent of the poverty guideline for your family size and state of residence. The poverty guidelines are maintained by the U.S. Department of Health and Human Services. Was this page helpful?
What is a key example of discretionary? ›A discretionary expense is voluntary spending. You want to buy something, but it isn't mandatory. Entertainment and recreational purchases fall into this category. On the other hand, bills such as rent, mortgage payments and utilities are nondiscretionary expenses.
What is an example of discretionary good? ›Examples of consumer discretionary products and services can include durable goods, high-end apparel, entertainment, leisure activities, and automobiles. Companies that supply these types of goods and services are usually either called consumer discretionaries or consumer cyclicals.
What is the discretionary rule? ›Discretionary acts are not governed by regulations, but rather by persons in roles of authority who judge each specific case, which means an act (such as review by the court of a particular matter) is at the free choice or judgment of the court.
What are the top 3 discretionary expenses? ›Three good examples of discretionary spending are entertainment, hobbies and leisure travel expenses. Although they might have a positive effect on your life, and maybe even your physical and psychological well-being, expenditures in these budget categories are wants, not needs.
What is discretionary income used to pay for? ›Discretionary income is the money you have left over after paying taxes and necessary cost-of-living expenses—like your rent or mortgage, utilities and groceries. It's called “discretionary income” because it can be used for discretionary expenses—nice-to-haves but not necessities.
Why is discretionary income important? ›Discretionary income is what someone has left over for saving or spending after taxes and living expenses have been paid. Because discretionary income can be spent on non-necessary goods and services, high per-capita discretionary income can be an indicator of a healthy economy.