Business Valuation Blog | Understanding Buying / Selling a Company

Like many professions, the appraisal industry is full of acronyms that only those well-versed in the lingo can identify at first glance. Here are a couple of abbreviated terms that will factor significantly in the overall valuation of your small business.

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization

Even the long version of this acronym is confusing to understand. Here is a short discussion of its meaning and purpose:

EBITDA is a measurement to determine a company's profitability or cash flow, however, it may not fully represent cash earnings. EBITDA considers a wide range of factors in business finances. It is considered a universally accepted appraisal measurement and is also used in accounting circles.

From an application perspective, it is used by banks and financial services companies to estimate debt servicing levels. It is also used to compare similar businesses within an industry or market and as a tool to preliminarily estimate a company’s current value using multiples of EBITDA developed from historic databases.

SDE: Seller’s Discretionary Earnings

Seller's Discretionary Earnings (SDE) is a calculation that considers the net profit of a business while adding back discretionary adjustments to show the entire financial benefit provided to an owner.

SDE is a common income measurement calculated when a business is changing hands. Financial data associated with this calculation include EBITDA, as well as other factors that impact a company's value as you engage in a buy/sell transaction.

If you're on the purchase or acquisition side, SDE provides you with the information needed to develop a reasonable estimate of your expected future return, as well as an understanding of realistic expectations for the continued growth of the business. From the seller’s viewpoint, SDE supports an optimal level of value during sale negotiations. SDE allows both buyers and sellers to make informed decisions while preparing to invest in or exit a small business.

In summary, these are only 2 of several acronyms commonly utilized in the business valuation industry. Our next blog will discuss other terminology that may be important to better understand when you decide to appraise a privately owned company.

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.

What is Seller's Discretionary Earnings (SDE)? As the wording suggests, it's a type of earnings or income that is calculated when a business is changing hands. But how is it different than other types of income you may see in the business world and how will it impact either your company or personal taxes, especially as it can impact a company's value as you enter the sale process. Here's a quick look into exactly what SDE is and how it can affect your finances.

What is Seller's Discretionary Earnings (SDE)? A Quick Look at this Earnings Type

Let's take a look at SDE based on each side of the equation during a business sale. If you're considering buying a business, the seller's discretionary earnings provides you with the information you need to develop an accurate prediction on your return on investment as well as get a better understanding on how realistic your expectations are of the business itself. For the seller, this calculation allows you to maximize your business' overall value before you get into sale negotiations. Preparing a business for sale can often bring up a range of various expenses which may or may not have an effect on a company's overall valuation. Understanding SDE allows you to make smart decisions while preparing to sell.

But how exactly is SDE calculated? If you've been following our blog, you may have seen the explanation of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) a few posts ago. SDE is a combination of EBITDA and owner's compensation. Here's a look at what is often considered to be part of calculating owner's compensation:

• The benefit expected to be given to one owner. As a standard part of this calculation, this is an adds one owner's compensation back. This is especially important when a share of a business or partnership is being sold. When several owners actively participate in operating the business, the calculation requires that projections be calculated to determine the value of the selling owner's effort and labor in the company.
• One-time expenses that were paid. These expenses cover a wide range of single purchases, but can include things such as a website design service, purchasing a specific license, an application fee for a particular service, benefit or membership as well as any number of other one-time expenses to the company.
• Non-business-related income or expense. Did you run consulting income through an e-commerce business? Was there a little extra time you took for personal time on a business trip? Maybe you charged your business rent for the cost of your home office. If you needed to put an automobile expense through your company when it doesn't typically need a car to do business, that's another example.
• Adjusted expenses. Let's say your business has a small website but also a large warehouse. The expense of the warehouse to fill orders must be adjusted as part of the website's expenses and is worked into the business' overall earning statements.

What is Seller's Discretionary Earnings (SDE)? By having the answer to that question, you gain a much better grasp of exactly how your business' finances function and what changes you can expect as a business changes hands. Understanding this type of income calculation means you can better understand how a company is being valued based on this type of income and how it will impact your final business value figure for the sale.