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.