Seller’s Discretionary Earnings: What It Is and How It WorksBy Los Silva
While the name may imply that this concept is only for the seller, Seller’s Discretionary Earnings is actually just a big term for a simple idea: It’s how much true cash (profit) the owner receives from their business. This number is used to set the price for a business.
So, let’s say you want to sell your business. How do you know how much you should sell it for?
On the flip side, let’s say you want to buy an online business. How do you know how much you should pay for it?
The answer to both questions, actually, lies in why someone is really buying a business in the first place:
When someone buys a business, they are hoping that the business will produce more cash, in the long run, than the amount of money they will spend to buy the business. In other words, they are hoping for a good return on investment (ROI).
So, the answer to how much a business should be priced lies in how much the business will likely produce, in cash (the amount of money the business makes beyond its debt payments and expenses), over the next several years.
Think of a business as a machine whose whole purpose is to produce cash.
To determine how much you should sell (or buy) this machine for you need to know how much cash the machine is expected to produce in the near future.
If you are the seller, you will want to sell your machine for more than what the machine is expected to produce.
If you are the buyer, you will want to buy the machine for less than what the machine is expected to produce.
Not surprisingly, at the end of the day, the actual price paid for the machine comes down to a compromise between what the seller and the buyer are both willing to accept.
But how do you know or figure out, whether you are the seller or the buyer, how much the business (machine) is expected to produce in the near future?
Enter Seller’s Discretionary Earnings.
Seller’s Discretionary Earnings (SDE for short) is simply the total earnings (or cash) the owner gets from owning the business each year after all business expenses are paid for.
Hence the reason its called Seller’s Discretionary Earnings – its how much money the owner can do with at their discretion after all bills and debt payments have been paid.
That cash, the SDE, is really what the buyer of a business is buying and, therefore, it is used in the setting the price of a business.
As such, for buyers, if a machine costs more to maintain than it produces, then the SDE would be a negative number and the machine would not be desirable.
However, if a machine produces much more cash than it costs to maintain it, then the SDE would be very high and machine would be in great demand and/or very desirable; a high SDE will increase the list price of a business.
How to calculate the SDE
There are four steps to determine the SDE:
Step 1: Get the Income Statements (or tax returns) for the last three (3) years.
Our goal here is to determine how much cash the business has generated for the owner in the recent past (at least the last three years) so that we can use that as a guide for determining how much cash the business will generate in the near future.
We need to start with getting accurate financial reports, and that means we need either the Income Statement or the businesses’ tax returns for the past three years.
Step 2: Add back to the Net Profit line any expenses that didn’t have anything to do with the actual operations of the business.
The buyer is buying a businesses’ projected cash production based on its operations. There may be many expenses that are listed on the Income Statement that have nothing to do with operations and, likely, are only there because of the current owners’ financial situation.
These are expenses that exist due to decisions made by the current owner. In other words, if a different owner owned the business those expenses would likely not be the same.
For example, if the current owner incurred debt on the business then he or she likely is paying interest and therefore would reduce the profit of the business. The buyer of this same business may be self-funded and not need to incur debt, therefore he or she would have no interest expense that would reduce the profit of the business. Other examples of non-operational expenses include depreciation and amortization.
Step 3: Add back to Net Profit any expenses that were one-time expenses – those that will not be incurred again the near future.
Take another look at the Income Statement. If, in the past three years, there were any large expenses that will likely not be incurred again (or, at least, over the next three years) then those amounts need to be added back to the Net Profit line. Examples could include major construction projects or equipment purchases.
Remember, our goal is to get an accurate picture of how much cash the business will generate in the near future and these large one-time expenses will skew that number.
Step 4: Add back to Net Profit the owner’s salary, benefits, and other perks (regardless if they have anything to do with operations of the business).
Of course, regardless of the health of the business, the current owner is reaping some monetary benefits from the business, such as a salary and health insurance. Those particular expenses will appear on the Income Statement and will also need to be added back to Net Profit. These usually include three main things: the business owner’s salary, benefits, and other perks.
The business owner’s salary is how much the business owner has been able to take, in the form of salary, over the past three years.
The business owner’s benefits include all the ancillary benefits that have been expensed by the owner, for the benefit of the owner (and his or her family), such as health insurance, retirement plans, and meals.
The perks are all the other expenses that the business owner deducted that would likely not apply to the new owner. For example, the previous business owner may have expensed their personal vehicle, their wife’s or kid’s vehicles, a family vacation or golf memberships.
Download an easy to use Excel template that will calculate SDE for you.
How is SDE used to calculate the actual selling price of a business?
By determining the average SDE the original business owner benefited from over the last three years we have the basis for what we expect the SDE will be, on average, over the next few years.
So, to determine the listing price of a business it is a widely accepted practice for most sellers to multiply the SDE by a certain number that is supposed to represent how many “times” the new business owner should pay now to reap the SDE later. That certain number, called a multiple, is based on industry averages and other similar businesses’ that have sold recently.
For example, if the average SDE over the past three years of a particular business was $100,000 and the average multiple in this particular industry was 3.5, then the business would be priced at $350,000 ($100,000 x 3.5).
The moral of the story
The moral of the story is: if you want to get a higher price for your business you must increase the SDE. That is to say that the business must produce more cash, which starts with producing more profit.
Remember, because most business buyers are looking to buy something that will produce cash, determining the SDE is a great way to show how much cash the business can reasonably be expected to generate in the next few years.
No method of pricing a business is perfect. However, setting a price using SDE as a basis is a very realistic method for pricing businesses. The seller gets the future “cash production” now. Likewise, the buyer gets something that will produce cash over the next several years.