Business Valuation Blog | Understanding Buying / Selling a Company

Seller’s Discretionary Earnings (SDE) is a measure of the total earnings available to an owner-operator of a business. It is commonly used when analyzing small, single-owner businesses and is an important consideration when determining business value.

SDE is essentially EBITDA (earnings before interest, taxes, depreciation, and amortization), plus the owner’s compensation and benefits, along with appropriate normalization adjustments.

SDE answers the question: “What is the normalized financial benefit generated by the business for a single owner-operator?”

Understanding SDE can help business owners and potential buyers evaluate the normalized earnings of a business and how those earnings relate to value.

How Is Seller’s Discretionary Earnings Calculated?

SDE is intended to reflect the normalized financial benefit available to a single owner-operator, including business earnings, owner compensation and benefits, and appropriate adjustments to reported earnings.

A simplified SDE calculation may look like this:

Pretax net income

+ Interest expense

+ Depreciation and amortization

+ Owner’s compensation and benefits

± Appropriate normalization adjustments

= Seller’s Discretionary Earnings

The actual calculation for any given business can be more complicated. Financial statements often require normalization adjustments to account for unusual, nonrecurring, personal, or non-operating income and expenses.

The important distinction is that an expense is not automatically an add-back to seller earnings simply because the business owner considers it discretionary. Adjustments should be reasonable, supportable, and appropriate for the valuation being performed.

What Expenses Can Be Added Back to SDE?

Potential SDE adjustments vary by business but may include:

Owner compensation and benefits

For a business operated by a single owner, the owner’s salary and payroll costs, health insurance, qualifying vehicle expenses, and other benefits may be considered when calculating SDE.

Nonrecurring expenses

A significant expense that is unusual and not expected to recur may warrant an adjustment. The appraiser should consider whether the expense is truly nonrecurring and whether a buyer would reasonably expect to incur the expense, or a similar expense, in the future.

Personal or discretionary expenses

Privately held businesses sometimes pay expenses that provide a personal benefit to the owner and are not necessary to the ongoing operation of the business. These expenses may be considered for adjustment when they can be identified and supported. In closely held businesses, personal and business expenses are frequently intermingled, which can make it more difficult to identify and support discretionary owner expenses.

Non-operating income and expenses

Income or expenses unrelated to the normal operations of the business may also require adjustment when developing normalized earnings.

Every business is different, and adjustments should be evaluated individually rather than simply added back based on a predetermined list.

What Is the Difference Between SDE and EBITDA?

Seller’s Discretionary Earnings and EBITDA are both measures used to analyze business earnings, but they are not the same.

EBITDA represents earnings before interest, taxes, depreciation, and amortization. SDE typically starts with EBITDA and goes one step further by also considering the compensation and benefits of the owner, along with appropriate discretionary and nonrecurring adjustments.

SDE is therefore commonly associated with smaller businesses in which the owner actively works in the company and controls their own compensation and many of the company’s financial decisions. EBITDA is more commonly used for larger businesses and businesses where management compensation is treated as an ongoing operating expense.

The appropriate earnings measure depends on the business, ownership structure, and purpose of the valuation.

How Does SDE Affect Business Value?

SDE is commonly used as an earnings measure when analyzing transactions involving small, owner-operated businesses. Market data may indicate relationships between the selling prices of comparable businesses and their SDE.

However, SDE alone does not determine the value of a business.

Two businesses with the same SDE can have significantly different values because of differences in growth, customer concentration, owner dependence, competition, management depth, recurring revenue, and other risk factors.

A business valuation considers the appropriate earnings of the company together with the risks and market factors associated with generating those earnings.

Why Are SDE Add-Backs Important?

Add-backs can have a significant effect on calculated SDE and, consequently, on an indication of value developed using an SDE multiple.

For this reason, potential adjustments should be carefully analyzed and supported. A claimed expense may be discretionary to the current owner but still represent a cost that a hypothetical buyer would need to incur.

For example, the compensation of one owner-operator is generally considered in calculating SDE. However, if multiple owners work in the business, compensation for additional owners may need to be replaced with the market cost of employees or managers needed to perform those functions.

The Bottom Line

Seller’s Discretionary Earnings can be a useful measure for understanding the earnings of a small, owner-operated business. However, determining SDE involves more than simply adding expenses back to reported profit.

A qualified business appraiser will analyze the company’s financial statements, identify appropriate normalization adjustments, and determine which earnings measure is appropriate for the valuation. SDE can be an important part of that analysis, but it is only one of the factors considered when determining the value of a business.

Common Questions

What does SDE mean in a business valuation?

SDE stands for Seller's Discretionary Earnings. It is an earnings measure commonly used for small, owner-operated businesses and generally reflects the normalized earnings available to one owner-operator, including that owner's compensation and benefits.

Is SDE the same as profit?

No. Reported profit reflects the income and expenses recorded by the business. SDE adjusts reported earnings for certain items such as owner compensation and benefits, interest, depreciation and amortization, and qualifying discretionary or nonrecurring expenses.

Are owner distributions added back when calculating SDE?

Generally, no. Owner distributions typically do not reduce reported business earnings and therefore are not added back when calculating SDE. Owner compensation that was recorded as an expense, however, may be added back when determining SDE.

Is SDE the same as EBITDA?

No. EBITDA excludes interest, taxes, depreciation, and amortization. SDE generally includes additional adjustments, most notably the compensation and benefits of one owner-operator.

Can all owner expenses be added back to SDE?

No. An expense should not be added back simply because it benefits the owner or is labeled discretionary. Adjustments should be supportable and should reflect the appropriate treatment of the expense for the valuation being performed.

Is a business worth a multiple of SDE?

SDE multiples are commonly observed in transactions involving smaller owner-operated businesses, but applying a multiple to SDE does not automatically determine the value of a business. The appropriate multiple and valuation method depend on the company, industry, risk factors, market evidence, and purpose of the valuation.

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.