Whether you’re interested in exiting your company or planning on acquiring a business, you have likely heard about SDE calculation or SDE business valuation. This is an important concept within buying and selling companies as the result of the calculation forms the basis of negotiations. Learn more about this valuation method in the following sections.
Key Takeaways
Seller’s Discretionary Earnings method measures the total financial benefit for a small business owner, adding back personal, discretionary, or one-time expenses to net income. Unlike EBITDA, SDE reflects owner-managed SMBs’ true earning power, requiring extensive adjustments for valuation, especially for “Main Street” businesses under $5 million.
SDE calculates a business’s true earning power by adding back to net income the owner’s salary, non-cash expenses (e.g., depreciation), interest expense, one-time expenses (e.g., website setup fees), and non-operational expenses (e.g., personal travel). These adjustments reflect a small business’s ongoing profitability.
When calculating Seller’s Discretionary Earnings, avoid common pitfalls to arrive at an accurate figure. Neglecting owner benefits, such as personal expenses paid by the business, undervalues the company. In multi-owner businesses, avoid adding back all owner salaries, as new management may require hired help, misadjusting the calculation. Additionally, failing to add back one-time, non-recurring expenses distorts the company’s true financial performance, leading to an inaccurate SDE valuation.
What is SDE in business valuation?
A comprehensive definition of SDE:
Seller’s Discretionary Earnings (or SDE) represents the total financial benefit a full-time business owner/operator can expect to get from a business in a given year. It is calculated by taking the business’s net income and adding back expenses that are personal, discretionary, non-operating, or one-time in nature — such as the owner’s salary, personal travel, non-essential employees, and non-recurring legal fees. SDE is also known by the following terms:
Adjusted Cash Flow
Total Owner’s Benefit
Seller’s Discretionary Cash Flow
Recast Earnings
Why SDE is particularly relevant for small to medium-sized businesses:
SMBs often reflect the owner’s personal financial choices within their financial statements. Unlike larger companies that typically rely on EBITDA and have professional management structures, such companies are usually closely managed by the owner, making SDE a more accurate representation of the business’s true earning power for a new owner-operator. This method is especially important when valuing “Main Street” businesses — generally those generating less than $5 million in annual revenue.
How SDE Differs from EBITDA and Other Financial Metrics:
Focus. EBITDA looks at operational profitability for larger corporations, while SDE captures total owner benefit in smaller, owner-operated companies.
Clarity. EBITDA is standardized. Non-operating costs are excluded from the financials. SDE is less clear due to owner salaries and personal expenses mixed in. The said aspects of SDE aren’t found in other financial metrics.
Adjustments. EBITDA requires minimal adjustments, but SDE needs extensive addbacks (positive or negative) to reveal true operational earnings.
Use Case. EBITDA suits corporate evaluations, while SDE is used for valuing small businesses where owner discretion will impact finances.
Calculating Seller’s Discretionary Earnings (SDE) comes with adjustments to the business’s financials with the goal of presenting the true earning potential.
Here’s a breakdown of each component in the formula:
Net Income/Earnings Before Taxes (EBT). The profit or loss of a business after subtracting all expenses from revenues.
Owner’s Salary. In SDE calculations, the owner’s salary is added back to reflect that the owner might pay themselves more or less than a standard manager’s wage.
Non-cash Expenses. These are expenses such as depreciation and amortization that lower net income but do not involve actual cash payments.
Interest expense. Interest expense from business debt is added back into the calculation, as a new owner might have different financing terms.
One-Time Expenses. These are costs that occur only once and are not expected to repeat in future operations. Examples include fees for setting up a new website, obtaining business licenses, filing special applications, or covering legal costs for isolated events. Since they do not impact ongoing profitability, they are added back when calculating SDE.
Non-Operational Expenses. This refers to costs that fall outside the business’s primary operations. Personal vacations charged as business travel, unrelated consulting income, fuel, and vehicle expenses in companies that do not use vehicles for work, or rent paid for a personal office space are all examples. These amounts are excluded to reflect only the true operating performance of the company.
How to Calculate SDE: Step-by-Step Process
Gathering necessary financial documents. Your business broker will determine your Seller’s Discretionary Earnings (SDE) by beginning with your company’s pre-tax profit and adjusting for specific costs, such as owner’s salary, interest expenses, depreciation, amortization, and non-essential or one-time expenditures. These amounts are extracted from your business’s financial statements. To support this calculation, you may be required to submit:
Federal tax returns (covering three or more years)
Income statements (profit and loss reports)
Balance sheets
Customer revenue breakdown (showing each customer’s contribution to total revenue)
Identifying add-backs. Add-backs typically belong to one of five groups. These categories differ across businesses, but knowing helps you determine which items to decrease or increase to make the SDE accurate.
Standard
Discretionary
One-time
Non-operational
Accounting-related
SDE calculation example with numbers:
Step 1: Based on The Brewer’s financial statements, the following numbers are identified for the most recent fiscal year:
Net Income/Earnings Before Taxes (EBT): $75,000
The figure represents pre-tax profit after all operating expenses, as seen in the income statement.
Owner’s Salary: $60,000
The owner-slash-manager pays themselves an annual salary.
Non-cash Expenses:
Depreciation: $10,000 (e.g., depreciation on equipment and furniture). The establishment doesn’t own intangible assets. To achieve simplicity in this calculation, there will be no assumed amortization.
Interest paid on a small business loan for equipment purchases: $5,000.
One-Time Expenses: $8,000
A one-time expense for a major repair to the shop’s HVAC system. It is not expected to recur.
Non-Operational Expenses: $3,000
Expenses unrelated to core operations, such as a donation to a local charity event sponsored by the business.
Owner’s Salary. The discretionary compensation for the owner’s contributions. The new management is free to choose their own salary.
Non-cash Expenses. Depreciation is a non-cash accounting expense that won’t affect the available cash flow.
Interest. The new management may have a different debt structure from the seller.
One-Time Expenses. The HVAC repair is non-recurring.
Non-Operational Expenses. Charity donations are unrelated to core business operations.
Step 5: Result
The SDE for The Brewer is $161,000 for the year. This figure represents the total pre-tax cash flow available to the owner and comes with adjustments for discretionary and non-recurring items.
Ensure an accurate calculation by avoiding the common mistakes when calculating SDE listed below:
Don’t forget to account for owner benefits. Failing to do so renders the company undervalued.
Misadjusting for multiple owners. Don’t add back all salaries in a multi-owner business, because the management taking over may need to hire help for those roles.
Missing one-time expenses. Every non-recurring should be added back to achieve accuracy in terms of financial performance.
FAQ
How can a business owner maximize their valuation by understanding how to calculate seller’s discretionary earnings?
Determine all owner benefits accurately. Thoroughly calculating SDE, which includes adding back the owner’s salary, perks, non-cash expenses (like depreciation), interest, one-time expenses, and non-operational costs to pre-tax earnings, will arrive at a higher cash flow. It will also reflect the full financial benefit to the owner and increase the business’s perceived value for potential buyers.
Highlight true earning potential. Understanding SDE allows owners to showcase the company’s operational profitability once it’s adjusted for discretionary and non-recurring items. This clearer picture of sustainable earnings can fetch a higher asking price when selling or restructuring.
Prepare for Strategic Positioning: Learning about SDE calculations enhances the owner’s ability to optimize the items within the financials (e.g., reducing non-essential expenses or documenting one-time costs). As a result, they acquire the ability to strengthen the financial profile of the company. This brings maximized valuation that’s positioned as an attractive investment with the potential for scaling.
Why are SDE valuation methods preferred for valuing owner-operated businesses?
The owner is the main operator of small businesses like service providers, restaurants, and small retail stores. Hence, the use of SDE. It clearly shows buyers the business’s take-home profit, so it is a popular method for small business valuation.
Are there any limitations to using the seller’s discretionary earnings formula in business valuations?
Subjective Adjustments: What the seller views as an add-back might not be the case from the perspective of buyers. Disputes potentially arise because of such disagreements.
Best for Small Businesses: SDE suits businesses with revenues under $3–$5 million, while larger firms will undergo valuation using the EBITDA method to achieve accurate values despite complex operational structures.
Overlooks Intangibles: SDE focuses solely on financial metrics, ignoring valuable intangible assets such as brand reputation or intellectual property.
Relies on Status Quo: SDE assumes the business will continue unchanged, but a new owner’s alterations could shift earnings, limiting SDE’s predictive accuracy.
How can a buyer verify the accuracy of a seller’s discretionary earnings during due diligence?
The result can be verified using the data sets, which is based on the financial statements of the seller.
Conclusion
Recap of SDE’s importance in business valuation + tips for optimizing your business’s SDE
Accurately Calculate SDE. Add back the owner’s salary, non-cash expenses (e.g., depreciation), interest, one-time, and non-operational expenses to net income to reflect the true earning power of the company.
Showcase sustainable earnings. Make the operational profitability apparent by adjusting for discretionary and non-recurring items to attract higher valuations.
Optimize financials by lessening non-essential expenses and document one-time costs to strengthen the company’s financial profile.
Position your company strategically to end the deal successfully. Use the SDE method to present the business as an attractive, scalable investment for potential buyers.
