Understanding Seller’s Discretionary Earnings

So you’ve heard someone throwing around the term “Seller’s Discretionary Earnings” and you find yourself thinking “my earnings aren’t discretionary at all.”  Let’s jump in and understand this oft-misunderstood term (which also, confusingly, goes by “Seller’s Discretionary Income,” SDE, and SDI…).

What is SDE?

The simple answer is: Seller’s Discretionary Earnings (“SDE”) is an estimate of the total financial benefit a full time owner operator would derive from the business on an annual basis.  It is also variously referred to as Seller’s Discretionary Cash Flow, Adjusted Cash Flow, Owner Benefit, Total Owner’s Benefit, Recast Earnings or Normalized Earnings.   It’s also most often used in “Main Street” sized companies.  While there is no hard and fast definition of what a Main Street business is, we rarely see anyone using SDE as a metric in companies in the $5 million revenue range or above.

How is SDE Calculated?

The short answer is:

       SDE = Adjusted EBITDA + Owner Compensation

The long answer is …. it depends.  Let’s start with EBITDA.   EBITDA is Earnings (aka Net Income) + Interest + Income Taxes  + Depreciation + Amortization.   (We’ll be writing on soon about just what the heck EBITDA is and why you should… or should not… use it).

Once we have EBITDA we need to work through normalizing adjustments and owners comp. When we think normalizing adjustments we often break those into two categories: discretionary items and non-discretionary items (learn more here).

Discretionary Expenses

Discretionary expenses are defined to be ones that the business paid for but are primarily of a personal benefit to the owner(s). Typical expense categories (places to check on your tax returns/ P&Ls) are owner medical or life insurance, travel, automobiles, meals and entertainment, dues and memberships.

To qualify as discretionary, each expense must meet all 4 of these criteria:

1) Benefit the owner(s)

2) Not benefit the business or the employees

3) Are paid for by the business and expensed on tax returns and P&Ls

4) Be documented and verifiable by a prospective buyer as discretionary.

Of course, by their very definition these types of adjustments can be debatable.

* This is an actual example!

Areas of Disagreement

As you can imagine discretionary expenses are often the matter of ample debate between a buyer and seller.  Seller’s want to get the “tax benefit” of expensing these items, but also want the benefit of adding them back into earnings when it comes time to sell. Buyer’s, of course, are risk averse and dubious about all these co-mingled expenses the seller claims are “not really expenses.”   In our experience the top areas of disagreement (in no particular order) are:

• Normalized Owner’s Compensation.  What’s the right number?  How will this impact valuation?  In small deals using SDI (and this article!) we don’t have to worry about owner comp.  But in larger deals it can have an enormous impact on negotiations.
• One Time Expenses.  Did that bad debt really only happen once?  Or will it likely happen on a routine basis?

So What?

When it comes to M&A transactions, realize that buyers are principally concerned about risks:  What don’t they know?  What aren’t you telling them?  How could this investment go bad?  We often say that getting to closing is about removing roadblocks in the deal – and often, the biggest amongst them is reducing the buyer’s level of perceived risk, with that in mind its 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.  Simply put – the cleaner your financials are the more likely you are to cash out on the best price and terms.