Understanding Seller’s Discretionary Earnings
You have decided to get a valuation on your business. It’s time to sell, or maybe you have received an unsolicited offer and are looking for a way to increase the value of your business.
You want to retire from the grind and receive a fair price. Still, you know that your $150,000 salary, equipment depreciation, and interest expenses are reducing your company’s actual value compared with others who may have lower taxes and fewer recurring expenses.
Your accountant tells you that it’s time to make a recast financial statement. The statement should cover the past two or three typical years of your company’s performance. You’ll also need a statement of the Seller’s Discretionary Earnings (SDE) — or Seller’s Discretionary Income (SDI).
What is SDE?
SDE is an estimate of the total financial benefit a full-time owner-operator derives from the business on an annual basis. It is a valuation term applied to a company whose gross receipts are below $5 million. Discretionary expenses are those expenses your business incurred but primarily benefitted the owner. They also include other expenses and certain so-called add-backs (see below).
EBITDA And how SDE is calculated
SDE is measured by what is known as EBITDA, an abbreviation for Earnings Before Interest, Taxes, Depreciation, and Amortization. When you add owner’s compensation to EBITDA, you get SDE—a depiction of the total financial benefit of your company’s earnings before the “ITDA” kicks in.
The full financial benefit is calculated in a process that reverse engineers—in the sense of adding back—some of the data included in the financial statements required for a business valuation. The items added back have the effect of decreasing your expenses and raising your bottom line.
Again, the real earning power of your company is often (but not always) reflected by its net income before it carries the burden of the owner’s high salary and taxes, along with company interest and depreciation expenses.
Pros and Cons of EBITDA
The bottom line is that EBITDA paints a broad stroke on how a business performs over the years. EBITDA is most helpful in comparing companies against each other with known industry averages.
EBITDA does not, however, show the true value of a company’s liquid assets or real income. The add-backs could also be the result of overly-optimistic accounting and the cause of disputes between the buyers and sellers.
Additionally, while EBITDA is a significant earnings metric, it differs from free cash flow, which measures the true earnings available to investors. The above can distort a firm’s true earnings potential, painting a misleading picture of performance and value.
The effects of “add-backs.”
SDE normalizes all your financial statements so prospective buyers can estimate your true cash stream with adjustments known as “add-backs.” An add-back can be a portion (or all) of those expenses added back to your net income.
Your goal is to demonstrate your company’s actual earning capacity “normalized” to industry standards compared with other companies in your category. Other companies might not have the same discretionary expenses, so add-backs level the playing field.
Add-backs are considered discretionary because the buyer would not be responsible for that expense after buying your business. As you remove—i.e., add back—those expenses, the SDE effectively shows a higher value of your business by returning that money to the bottom line.
You originally included all those discretionary expenses to keep your tax exposure low and take every tax credit/deduction. But those discretionary expenses—add-backs—do not reflect your true operating performance and will likely not continue under new management.
The Recast Income Statement Explained
Visualize a Recast Income Statement as a report in three columns:
Column 1: Income and expenses—before including add-backs.
Column 2: Add-back amounts (if any) subtracted from expenses
Column 3: The adjusted amounts of expenses after subtracting the add-backs.
Your SDE is the sum of column 3 subtracted from your gross profit. It will show reduced total expenses with an increase in the valuation of your company.
The bottom line: SDE is a way of leveling the playing field so prospective buyers can feel how your company stacks up against similar companies, unencumbered by discretionary expenses—again, normalized to industry standards.
What qualifies as a discretionary expense?
To qualify as discretionary, the expense must meet the below criteria:
1. The expense is for the sole benefit of the owner.
2. The expense does not benefit the business or employees.
3. The expense is paid by the company and reflected on tax returns and profit and loss statements.
4. The expense is documented and verifiable by the prospective buyer as discretionary. (See the heading below on differences of opinion between the seller and buyer.)
Types of add-backs normally included in SDE calculations
The most commonly accepted add-backs accepted as discretionary expenses include:
- The salary for one full-time owner
- Depreciation for company equipment
- Amortization and interest on loans
Non-recurring expenses can also be listed as add-backs for SDE purposes. They include:
- Bad debt expense
- Business relocation expenses
- Equipment upgrade/maintenance/repair
- Legal expenses
- Professional or consulting fees
- One-time technology upgrades
- Transaction-related charges/costs
Then there are other owner-related add-backs and expenses that contribute nothing to the company’s operating performance. They are not likely to continue under new management. Examples:
- The owner’s personal travel reimbursements
- Expenses for the owner’s or family members’ auto fuel charges
- Dues for club membership
- The owner’s health insurance premiums
- The owner’s personal or family member’s mobile phone charges
- Charitable contributions
Differences of Opinion Between Owners and Buyers Surrounding SDE
Disputes over gray areas in calculating discretionary expenses can lead to differences of opinion and complicate sales negotiations. For example:
- Only one salary can be added back to total earnings if there are several owners. Which salary goes in the add-back column, and which one is considered a normal employee?
- Are club membership costs really for business? Shouldn’t meeting wealthy and influential clients through club memberships be excluded from discretionary expenses? On the other hand, aren’t hundreds of thousands of deals made in social settings?
- Is the seller’s social media and web presence an actual or discretionary expense? Is it reasonable for the seller to include website upgrades expenses when calculating discretionary expenses?
Nothing Worth Doing is Easy
Objective and accurate business valuation is a job for professionals. Our valuation experts at Quantive can help you resolve disputes and decide on the best method you should use in arriving at the true value of your business.
We will help you gather the data and documents you need for a single fee. Our report will be your foundation that will pass the scrutiny of prospective buyers and serve as a solid basis for negotiation when it comes time to sell your business.
Contact us. Our experts are standing by to answer your questions.