Seller's Discretionary Earnings (SDE) is a type of income measurement that is calculated when a business is changing hands. SDE is a specific calculation involving earnings before interest, taxes, depreciation, and amortization (EBITDA), which was discussed in our last blog post, as well as other factors that impact a company's value as you engage in a buy/sell transaction. Here's a look into SDE and how it measures the value of a company

SDE is a useful tool from both the buyer and seller’s perspectives. If you're on the purchase or acquisition side, the seller's discretionary earnings will provide you with the information needed to develop a reasonable estimate of your expected return on investment (ROI), as well as obtaining an understanding of realistic expectations going forward for the business. From the seller’s viewpoint, this measurement allows you to support a high level of overall value during sale negotiations. Understanding SDE allows you to make informed decisions while preparing to buy or sell.

As noted earlier, SDE utilizes EBITDA and considers the owner's overall value to the company and the benefit they derive from the business, above any salary paid. Here is what is typically considered when measuring the owner's overall value, compensation, and benefit:

• Value estimate of the owner(s) overall contribution to the business: The owner’s value to the business is a combination of the revenue that can be directly tied to a specific owner, as well as the value derived from their day-to-day operation of the business. This is especially important when a share of a business or partnership is being sold with multiple owners. When owners actively participate in operating the business, this measurement requires that historic, current, and projected benefits be calculated to determine the value of the selling owner's sales efforts and overall labor in the company.
• One-time expenses: Owners benefits from the business include any number of expenses that are charged to the company and will cover a wide range of one-off or annual purchases, including items such as website design services, home office leasehold improvements, licenses, certifications, application fees, organization memberships, as well as any number of similar expenses to the company.
• Home office and business expenses reimbursed or charged to the company: These would include reimbursable monthly costs for the owner’s home offices, including rent, utilities, healthcare, life insurance, transportation, certain travel & living expenses, and related items.

With an understanding of how SDE and the owner’s overall contribution to the business are measured, you can gain a better understanding of your company’s overall financial health and how it is viewed in the industry. Seeking a more detailed independent measurement of value for your company, especially if you plan to sell, expand or refinance debt is always a sound idea. A certified business appraiser will provide you with the overall value of your company, as well as information on the market, industry, competition, and the strengths and weaknesses of your company.

How is your business organized? Many companies are aware of at least some of the benefits of organizing under each of the different business types, but did you know that there is at least a little difference between how each of these companies are organized and how they must be handled in the company valuation process? Here's a quick look at the differences between each basic business organization type and the impact it can have on your overall appraisal process.

How a Company Valuation is Different Between Business Organization Types

Sole Proprietorship

A sole proprietorship is the most basic legal organization a business can have. It can be one or multiple people acting in the interest of the business, but it's assumed that they act as one body in the interest of the company. It provides very little in terms of legal protection, so if your company were to be sued, you could also lose your home and other assets in the process. The higher level of liability must be factored into the potential for losses and any mixing of personal and business funds must be sorted out in the appraisal process.

Partnership

A partnership is more detailed than a sole proprietorship and should have some documentation laid out at the beginning of the partnership to determine who owns what amount of the company and what must be done should the partnership be dissolved. It helps avoid arguments at the end of the business by having everything in line ahead of time with regards to how to split up the profits or losses when the business closes or is sold. This process is taken into account during appraisal with each partner's share calculated from the total appraised value.

S-Corporation

Also referred to as a pass-through corporation, this type of corporation requires more paperwork to establish as a proper corporation, but also provides legal protections to the owners. However, unlike a C-corporation, an S-corporation passes earnings through to the owners, so rather than the corporation paying taxes on profits, the owners report these profits and pay the taxes on them on their personal tax returns. This can create additional growth that is factored in during an appraisal.

C-Corporation

A C-corporation is a fully incorporated entity that exists completely separate from the owners. Like the S-corporation, it requires more paperwork to incorporate, but the taxes on profits are paid by the corporation before they are distributed to the owners, at which point the owners also pay taxes. It also provides more legal protection to the owners as it stands as its own entity. This double taxation is taken into account in terms of the corporation's growth in appraisal.

Limited Liability Company

A limited liability company or LLC is a company or corporation that is specifically set up to limit the amount of liability a company or its owners may be exposed to in the course of doing business. It can be set up in any number of organization types, but is generally designed to provide protection to the owners rather than any specific tax or appraisal benefits.

By understanding the differences between business organization types, you can gain a better understanding of how each organization works and how it affects the way that you do business on a daily basis. It also provides you with opportunity to better understand the impact it can have on your company when it's time to have an appraisal performed. Make sure to work with a certified business appraiser when you have your company valuation performed to ensure you're getting the best possible information and accuracy out of your investment.

How much is a business worth? This question has plagued business owners for centuries. Unfortunately, the answer to that question, as to so many in life, is that it depends. What are you trying to do with the business? Why are business appraisals needed at that time? Will the current market conditions change the valuation of a company compared to a year from now? How does today's business owner figure out what their business is worth? Here's some quick insight into how a business is valued and the process that is used to calculate that value.

Exactly how do you figure out how much is a business worth?

Determining business value is a complex process. It involves looking at the business' individual practices, market share, goodwill in the community and income levels. It can also involve the market and industry conditions, the urgency of a sale, the perceived value of the company's brand and any number of other aspects that are often dismissed as inconsequential to the business value as a whole.

Part of the calculations are based on why the valuation is needed. If you need a valuation of your business because you're considering expanding and want to make sure you're on solid financial footing first, you'll need a completely different valuation than someone who is having to quickly sell a business to settle an estate due to an untimely death or the dissolution of a partnership or marriage.

Another area that can come into play is the current industry and market. If the business is positioned to take advantage of new technologies or innovations in the industry, the business' value to drastically increase beyond what the business owner may otherwise calculate. If, on the other hand, the business is floundering due to industry changes or poor market conditions, using an older business value may leave you open to risk as you overextend your credit trying to keep up with poor economic conditions.

Simply basing your business value on similar businesses that have sold recently may not give you an accurate view of your business' value either. If the business you are comparing to has a more favorable location, better position in the industry, specialties that you have not diversified into, different income levels or other aspects that impact the business' overall value, you may be under- or over-valuing your business' actual worth. 

Is your business a household name or a newcomer to the industry? This can make a big difference in how reactive your business will be to changes in market conditions. What about your reputation? A good reputation will often improve your business value as your customers perceive a higher value to the products and services you provide when compared to a competitor.

As you can see, the question of how much is a business worth is a very complicated one that requires significant experience to accurately answer. Fortunately, as a business owner, you don't need that experience. A business valuations specialist who has experience in your industry and special area of operation spends their days looking at businesses like yours to determine those values using standardized methodologies developed for specific situations.