SDE, or Seller's Discretionary Earnings, is a metric commonly used in the valuation of small businesses. It represents the earnings of a business before certain non-operational expenses. SDE aims to capture the true underlying earnings that a new owner could expect, especially when the current owner might be taking benefits that wouldn't necessarily transfer to the new owner.
Relevant Template:
- Small Business Valuation Model (4-way) - Printable visuals and sensitivity analysis template that displays up to six valuation ranges (low to high) across four valuation methodologies (including the SDE approach). This provides all formulas and calculation explanations for valuation based on EBITDA, SDE, DCF, and Revenue-based.
To calculate SDE, follow these steps:
- Start with Net Income: This is the starting point and is usually taken from the bottom line of the business's income statement.
- Add Back Owner's Salary and Benefits: Since SDE aims to show the discretionary earnings available to an owner, you add back any compensation or benefits the current owner is taking.
- Add Back Non-recurring or One-time Expenses: If there are any unusual, non-recurring, or one-time expenses that won't be expected to continue in the future, add them back. This could be things like legal fees from a one-time event, expenses from a rare event (like a natural disaster), or expenses from a one-off project.
- Add Back Non-operating Expenses: Add back any expenses that aren't related to the core operations of the business. Examples might include interest, taxes, depreciation, and amortization (often referred to as EBITDA adjustments).
- Add Back Any Other Discretionary Expenses: This can be a bit subjective, but the idea is to add back any expenses that a new owner might choose not to incur. For example, if the current owner spends excessively on business lunches or travels first class for business trips, these expenses might be added back to the SDE.
- Reduce any non-operating or irregular income that is not part of normal operations. This could be things like gains on stock (if your primary business is not a hedge fund) or insurance claims where you received a benefit.
The formula can be represented as:
{SDE} = {Net Income} + {Owner's Compensation & Benefits} + {One-time Expenses} + {Non-operating Expenses} + {Other Discretionary Expenses} - {Other non-operating income}
It's important to note that the calculation of SDE can be subjective, especially when determining what constitutes a discretionary expense. Therefore, it's essential to be transparent and provide clear explanations for any adjustments made, especially if presenting the SDE to potential buyers or investors.
When is SDE A Good Approach to Use For Valuation and When is SDE Not Suitable?
Seller's Discretionary Earnings (SDE) is a valuation method commonly used for small businesses. It represents the earnings available to the business owner before accounting for interest, taxes, depreciation, amortization, and the owner's compensation. SDE is used to provide a clearer picture of a business's profitability from the perspective of a potential buyer.
Types of businesses where SDE is a good valuation method:
- Small businesses: As SDE accounts for the owner's compensation, it's particularly useful for small businesses where the owner's salary might vary significantly from what a regular manager would earn.
- Owner-operated businesses: SDE is suitable for businesses where the owner plays a significant role in day-to-day operations. It reflects the true profitability without the often arbitrary or variable compensation to the owner.
- Main Street businesses: These are typically smaller, local businesses such as retail stores, restaurants, local service providers (like hair salons, pet grooming, etc.), and smaller franchises.
- Businesses with relatively simple operations: For businesses with straightforward financials and operations, the SDE can give a clear picture of profitability.
- Larger corporations: SDE is not generally suitable for larger corporations where EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a more standard measure.
- Businesses with multiple owners or partners: If a business has several owners or partners drawing varying salaries, the SDE can become complicated and may not reflect the true discretionary earnings.
- Companies in capital-intensive industries: For industries that require significant capital expenditures, such as manufacturing, the depreciation factor can be significant part of normal operating earnings over a long period of time and therefore should be accounted for in the valuation. Equipment and large items may need to be replaced over time and if you zero that cost out, it could give a valuation that is not as useful.
- High growth startups: Startups, especially SaaS tech startups, that are in the growth phase and might be running at a loss or with very variable earnings, might be better valued using other methods based on potential future earnings or market comparables.
- Businesses with complex financial structures: Companies with a lot of debt, complex financial arrangements, or extensive assets might be better analyzed using other valuation methods that account for these complexities.
