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