Introduction
If you’ve ever bought or sold a small business or had one appraised, you’ve likely encountered the term “Seller’s Discretionary Earnings” (SDE). You might wonder, “Discretionary earnings? My earnings aren’t discretionary at all!” Let’s delve into this often-misunderstood concept and compare it to EBITDA, another prevalent earnings measure.
What is Seller’s Discretionary Earnings?
Seller’s Discretionary Earnings (SDE) represents the total financial benefit a single full-time owner-operator would receive annually from a business. It is also known as Adjusted Cash Flow, Total Owner’s Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings. Here at Strategic Medical Brokers, we prefer the term Discretionary Earnings or DE, but we’ll stick with the more common SDE for this article.
SDE is primarily used in valuing and selling “Main Street” businesses. While “Main Street” is not precisely defined, it typically refers to owner-operated companies with less than $5 million in revenue. In contrast, larger businesses generally rely on EBITDA.
SDE vs. EBITDA
The formula for SDE is SDE = Adjusted EBITDA + Owner Compensation (one full-time owner). EBITDA is calculated as EBITDA = Net Earnings + Interest + Taxes + Depreciation + Amortization.
Therefore, SDE is always a larger figure than EBITDA. This can be counter-intuitive for those accustomed to the middle market, where EBITDA is often perceived as a large number from which net cash flow is calculated. The formula helps clarify this misconception.
When applying price multiples for sale or valuation, it’s crucial to distinguish accurately between SDE and EBITDA. A mismatch between the earnings measure and the multiple applied can lead to significant overvaluation or undervaluation of a business.
Normalization Adjustments
We need to perform normalizing adjustments after calculating EBITDA (or SDE) from a company’s profit and loss statement. These adjustments typically fall into two categories: discretionary items and non-recurring items.
Discretionary Items
Discretionary expenses are those incurred by the business that primarily benefits the owner personally. Owners often expense these items for tax benefits but add them back into earnings for valuation and sale purposes.
Common discretionary expenses include:
- Owner medical or life insurance
- Personal travel
- Personal automobiles
- Personal meals and entertainment
- Social club memberships
For an expense to be considered discretionary, it must:
- Benefit the owner(s)
- Not benefit the business or its employees
- Be paid for by the business and expensed on tax returns and P&Ls
Determining whether an expense is discretionary can be complex:
- Adjust: Retirement plan contributions, home landscaping
- Don’t Adjust: Networking group memberships, marketing expenses
- Gray Areas: Travel (business and pleasure), contributions
Discretionary expenses often spark debate between buyers and sellers. Buyers, wary of risk, may question the validity of these expenses. Items in the gray area require additional documentation and due diligence. Sellers generally benefit from avoiding commingling business and personal expenses for at least three years before selling their business.
Non-Recurring Items
The other major category involves extraordinary or one-time income or expenses. Adjusting for these makes sense as they do not indicate the core business operations. Common examples include:
- Restructuring costs
- Costs related to acts of nature
- Asset sales
- Litigation expenses
- Emergency repair costs
One-time expenses are also scrutinized and debated. Buyers may question if a bad debt occurred once or if it might happen again.
Why is This Important?
In mergers and acquisitions, buyers are concerned about risks: What are they not being told? How could this investment fail? Achieving a successful closing often involves removing perceived risks. Thus, it’s essential to consider the line items that contribute to SDE well before going to market. Reducing questionable areas can lead to cleaner financials, increasing the likelihood of selling at the best price and terms.
