As a business owner, if you have ever considered selling your business, had it appraised, or looked to grow through acquisition, you have come across the term Seller's Discretionary Earnings, often abbreviated SDE.
Most small to medium businesses (SMBs) use a multiple of SDE to derive a value, particularly those for sale. Use the calculator below to calculate your company’s SDE.
What we will cover in this article:
Seller's Discretionary Earnings (SDE)is a calculation of the total financial benefit that a single full-time owner-operator would derive from a business on an annual basis. SDE is referred by many similar names including: Total Owner's Benefit, Adjusted Cash Flow, Seller's Discretionary Cash Flow, Recast Earnings, or Owner's Discretionary Income (ODI).
Seller's Discretionary Earnings(SDE) are the pre-tax, and pre-interest profits before non-cash expenses, one owner's benefits, one-time investments, and any non-related income or discretionary expenses are accounted for. In addition, SDE may require that expenses be adjusted if a new owner will necessarily need to take on a new expense after the asset sale.
The idea is what part of earnings are getting expensed to the business and directly benefiting the owner. These costs will not transfer to the new owner because they are "discretionary" and not needed in operating the business.
SDE differs slightly from Earnings Before Interest Depreciation and Amortization (EBITDA). Many financial professionals, private equity, and MBAs are trained to think in terms of EBITA. It allows them to compare companies based on free cash flow outside of decisions about debt structures and tax considerations.
Most middle-market and large companies are not owner-operated. Here is the difference. SDE typically takes this into consideration allowing for one owner's salary to be added to the list of add-backs since the new owner will benefit. So SDE typically only applies in small to medium businesses (SMBs). There are no hard and fast rules to define SMB or Main Street Businesses. Typically, it refers to owner-operated companies with less than $5 million of revenue.
Sometimes you will hear SDE also referred to as adjusted EBITDA, particularly for larger SMBs.
SDE helps compare businesses' cash flows and values by "recasting" or" normalizing" their financial statements so prospective buyers, their lenders, and investors can estimate expected cash flows and more accurately compare your company to others.
The fundamental goal of identifying the seller's discretionary earnings is to accurately identify what a new owner can reasonably expect their annual earnings and discretionary cash flow to be. Of course, this then determines the sale price and market value.
Often, this calculation reflects a combination of art and math. Therefore, it is not uncommon for a buyer and seller to disagree about what to – or not to include – in their discretionary earnings number.