Understanding Seller’s Discretionary Earnings

If you have acquired or sold a small company, or had one appraised, you’ve probably heard the term “Seller’s Discretionary Earnings”. Or you may be thinking “Earnings are discretionary? My earnings aren’t discretionary at all!” Let’s examine this often-misunderstood term, and how it compares to EBITDA, another common earnings measure.

What is Seller’s Discretionary Earnings?

Seller’s Discretionary Earnings (“SDE”) is a calculation of the total financial benefit that a single full time owner-operator would derive from a business on an annual basis. It is also referred to as Adjusted Cash Flow, Total Owner’s Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings. Here at Exit Strategies, we prefer the term Discretionary Earnings or DE. For this article I’ll use the more common SDE.

SDE is most often used in the valuation and sale of “Main Street” businesses. While there is no precise definition of what a Main Street business is, it often refers to owner-operated companies with less than $5 million of revenue. Larger businesses primarily use EBITDA.

SDE vs EBITDA

SDE = Adjusted EBITDA + Owner Compensation (one full-time owner)
Where EBITDA = net Earnings + Interest + Taxes + Depreciation + Amortization.

So SDE is always a larger number than EBITDA. This is a bit counter-intuitive for people used to working in the middle market. They usually think of EBITDA as the large number that things are subtracted from to calculate net cash flow. And wouldn’t SDE be similar to or smaller than EBITDA? A look back at the formula clears this up.

When applying price multiples for sale or valuation purposes it’s important to accurately differentiate between SDE and EBITDA. A mismatch between the earnings measure used and the multiple applied can result in significantly overvaluing or undervaluing a business.

Normalization Adjustments

Once we calculate EBITDA (or SDE) from a company’s profit and loss statement, we need to work through normalizing adjustments. We often break normalizing adjustments into two categories: discretionary items and non-recurring items.

Discretionary Items

Discretionary expenses are those that the business paid for but are really a personal benefit to the owner. Discretionary expenses exist because owners want the “tax benefit” of expensing these items. But they also want the benefit of adding them back into earnings when it comes time to value and sell the business.

Typical discretionary expenses are owner medical or life insurance, personal travel, personal automobiles, personal meals/entertainment, and social club memberships. To qualify as discretionary, each expense must meet all three of these criteria:

  1. Benefit the owner(s)
  2. Not benefit the business or its employees
  3. Are paid for by the business and expensed on tax returns and P&Ls

Whether an expense is discretionary or not isn’t always obvious:

Definitely AdjustDon’t AdjustGray Areas
Retirement plan contributionsNetworking group membershipsTravel (business and pleasure)
Home landscapingMarketing expensesContributions

Discretionary expenses are often the subject of debate between a buyer and seller. Buyers, of course, are risk averse and dubious about all these co-mingled expenses the seller claims are “not really expenses.” Items that fall in the gray area will require extra documentation by the seller and due diligence by the buyer. Certain items that a buyer might accept won’t be accepted by a bank. Generally speaking, sellers will benefit from stopping all commingling of business and personal expenses at least three years before they sell a business.

Non-Recurring Items

The other major category is extraordinary/one time income or expenses. Adjusting for extraordinary one time income and expense makes sense because they are not expenses that are indicative of the core business operations. Common examples are restructuring costs, costs related to acts of nature, asset sales, litigation expense and emergency repair costs.  One-time expenses are also scrutinized and debated. Did that bad debt really only happen once? Or is it likely to occur again in the future?

Why is this important?

In M&A transactions buyers are concerned about risks: What aren’t you telling them? How could this investment go bad? We often say that getting to a closing is about removing roadblocks in the deal – and often the biggest among them is reducing the buyer’s level of perceived risk. With that in mind it’s important to think about the line items that go into SDE well before you go to market and do your best to reduce any areas that might fall into the “questionable” zone. The cleaner your financials are the more likely you are to sell on the best price and terms.

Bob Bates, CPA, CVA is a senior valuation analyst in Exit Strategies Group’s San Jose California office. For more information on the use of earnings and cash flow measures used in business valuation, or to discuss a current business valuation need, Email Bob at bbates@exitstrategiesgroup.com or call him at 408-769-4404.