Understanding Seller's Discretionary Earnings (SDE)

In business valuation, Seller's Discretionary Earnings (SDE) is a cash flow-based metric used to assess the total financial benefit an owner derives from their business, including the owner's salary and benefits. It is a key figure in valuing small businesses. Here's a closer look:

Purpose:

SDE helps both buyers and sellers understand the true cash flow and profitability of a business, particularly for small to mid-sized companies. It’s the starting point when trying to figure out what a business is worth for buyers, sellers, and banks.

Calculation:

To calculate SDE, you take the business's net operating income and add back the owner's salary and any discretionary or “one-time” expenses that aren’t part of regular operating costs. Basically, it answers the question for the buyer: “If I buy this business and operate it as the current owner does, how much money am I going to make?”

These expenses are called “add backs,” and the total of reasonable add backs and the net operating income of the business is SDE.

Key Differences from EBITDA:

While EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is typically used for valuing larger businesses, SDE is tailored for smaller businesses and incorporates the owner’s compensation as a key factor in the calculation. This generally assumes a buyer is going to come in and operate the business and take over the current owner’s responsibilities.

Importance:

Many small business owners do operate in a manner that effectively reduces taxable income. We all understand this. SDE is an essential metric for valuing a business because it offers a more accurate picture of the true cash flow that would be available to a new owner. This makes it easier for potential buyers to assess the possible return on their investment.

A buyer and a buyer’s bank are going to use this and come to an assessment of the value of the business based on the SDE and a negotiated “multiple” of that amount. The formula is:

Multiple × SDE = Sale Price

Multiples can vary depending on business size, SDE, and industry. Your Transworld Business Broker can give you valuable insight into the multiple you should expect for your business.

Other Names:

SDE is also known as Adjusted Cash Flow, Total Owner's Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings.

In the end, your business is not worth what you might want or think it is worth—it is worth what someone will pay for it.

If you would like to learn more about what the value of your business is, please reach out to Patrick Bombardiere at Transworld Business Advisors. You can contact me at patrick@tworld.com or call 303-929-9219.