How to Calculate Seller Discretionary Earnings
Posted by Kipp Krukowski on Wed, Dec 23, 2009 @ 06:23 AM
It is important to know how much money your business is making so that you can convey this to potential buyers since this is what they are going to use to base their decision on whether or not to purchase your business as well as how much they will pay you for your business.
When it comes to private businesses, it is likely that the only people that see the financials are the business owner, the business owner's accountant, and the IRS. Business owners that are not considering selling today or in the near future work creatively with their accountants to minimize their net income to pay less tax but maximize their lifestyles out of the business. They will often get creative in the items that are expensed through the business. While these may be perks to the business owner while he is not looking to sell, it becomes difficult to show the true profitability of the business to a potential business buyer if an owner becomes too creative in minimizing his profits but maximizing his lifestyle.
It is important to make sure that buyers and business sellers are speaking the same language when it comes to business earnings. The three most common ways of expressing earnings are Net Income (or Net Profit), EBITDA (Earnings Before Income Taxes and Depreciation), and SDE (Seller Discretionary Earnings).
Starting with Net Income, this is the easiest to identify for a business. This is the bottom-line profit as shown on the tax return or income statement. Though this is the easiest to identify, it is the least valuable of the three. Unfortunately in the small business world, it doesn't tell the story on how profitable the business actually is. Since the owner, his accountant, and IRS are the only individuals to see this number, their goal is to minimize it so that less taxes are paid. There is likely much more to the story buried in the expenses of the business.
The second most common way to calculate business earnings is using the calculation of EBITDA. Though it can be calculated for any business, EBITDA is really only useful when businesses are larger in size. Private Equity Groups or Investors not managing the day-to-day operations will typically use this term because the calculation looks at the earnings without making an adjustment for an owner/operator. They will have the expenses of a full-time president or manger running the operation while they are not involved in the day-to-day operations.
Seller's Discretionary Earnings is the key to any small business valuation and sale. This calculation shows the true earnings of a small business. To calculate SDE, you need to make adjustments to the income statements. This is often called recasting. Items that can be adjusted include Depreciation, Amortization, Interest, Officer Compensation, Family salaries/benefits, Officer Insurance, Officer Auto, Officer Fringe Benefits and Rent. These cannot always be added back for SDE. Sometimes they can affect the SDE in a positive way and sometimes a negative way. You must understand when you can adjust and when it must stay.
Even SDE can be calculated differently. Banks are more conservative calculators of SDE while business owners are more aggressive. Though a business owner may be expensing additional items through the business, a bank will only give credit to items that are documented and not questionable. These items include Net Income, Interest, Depreciation, Amortization, Owner W-2 Compensation, and any Non-Operating Expenses. The Non-Operating Expenses must be documented and legitimate one-time expenses in the eyes of the lender. Please note that the Business Value Estimator uses the bank’s methodologies in calculating SDE. By recasting aggressively using add-backs that are not one of these items, you may consequently calculate an inflated value of the business. It should also be noted that the Business Value Estimator only looks at actual transactions that were financed by a lender. If a business has issues, whether financial or non-financial preventing the business from being financed through a lender, the multiple, thus business value, will likely be lower than what is presented in the calculator.
DISCLAIMER: The Business Value Estimator is for entertainment purposes only. Though it is developed using information from actual transactions, there is the chance that information was entered or reported incorrectly thus altering the numbers provided. Do not use the Business Value Estimator for any important financial related decisions. Seek a certified third-party business valuation professional to find a value for your specific business and situation.
EBITDA and SDE are similar. The easiest way to think of EBITDA is that you calculate the SDE but then you subtract out a cost for a full-time manager's salary and benefits since there will be an expense for someone running the show.
It is important to know that you will not be able to accurately recast the financials of a business by just looking at the profit and loss statements or tax returns. You have to ask questions to understand where add-backs (or subtractions) may exist. The easiest way to think of it is to ask yourself, "If a new owner walked in today to replace me, what expenses are necessary to generate the current level of sales?" Remember that for every legitimate dollar that you can add-back, you will get paid a multiple of this when you sell your business.