What is the difference between EBITDA and Seller’s Discretionary Earnings (SDE)?
While both SDE and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) are measures of a company’s financial performance, they serve different purposes and are used in different contexts. Understanding the distinctions between these two metrics is crucial for accurate business valuation. Key differences between SDE and EBITDA:
Owner’s compensation:
SDE includes the owner’s salary and benefits
EBITDA does not include owner’s compensation
Business size:
SDE is typically used for small to medium-sized businesses
EBITDA is more commonly used for larger companies
Discretionary expenses:
SDE adds back discretionary expenses
EBITDA does not include discretionary add-backs
Standardization:
SDE provides a clearer picture of owner benefit
EBITDA offers a more standardized view of operational performance
Valuation multiples:
SDE multiples are generally lower than EBITDA multiples
EBITDA multiples are more commonly used in larger transactions
Calculating Seller’s Discretionary Earnings (SDE) accurately is crucial for business owners, especially when preparing for a sale or valuation.
Here’s a comprehensive guide to best practices for calculating SDE, ensuring you present a true picture of your business’s earning potential.
The foundation of an accurate SDE calculation is reliable financial data. Use audited financial statements or well-maintained accounting records as your starting point. Ideally, you should have at least three years of financial data to establish trends and smooth out any anomalies.
Key steps:
Ensure your books are up-to-date and accurate
Reconcile all accounts
Review and correct any discrepancies
Consider having your financial statements reviewed or audited by a CPA
Add Back Owner Compensation and Benefits
One of the most significant aspects of SDE calculation is adding back all compensation and benefits received by the owner(s). This step is crucial because it helps potential buyers understand the true earning potential of the business if they were to step into the owner’s role. Items to add back:
Owner’s salary and bonuses
Health insurance premiums
Retirement contributions
Life insurance premiums
Personal use of company vehicles
Other perks like club memberships or personal travel expenses
Remember, if there are multiple owners, typically only one owner’s compensation is added back, while the others are adjusted to market rates for their roles.
Identify and Add Back Discretionary Expenses
Discretionary expenses are costs that are not necessary for the core operations of the business and that a new owner might choose to eliminate or reduce. Identifying these expenses requires a thorough review of the company’s financial statements. Common discretionary expenses:
Personal travel and entertainment
Non-essential office expenses
Charitable donations
Family member salaries (if not at market rate)
Excess inventory
Be prepared to justify each add-back, as potential buyers will scrutinize these adjustments closely.
Add Back Interest, Depreciation, and Amortization
These financial elements are typically added back in SDE calculations:
Interest: Add back interest expenses, as a new owner may have different financing arrangements.
Depreciation and Amortization: These are non-cash expenses that don’t reflect actual cash outflows and are typically added back.
Identify and Add Back One-Time or Non-Recurring Expenses
Expenses that are unlikely to occur again under new ownership should be added back to SDE. However, be cautious about what you classify as “one-time” – some expenses may appear non-recurring but actually happen periodically. Examples of one-time expenses:
Legal fees for a specific lawsuit
Costs associated with rebranding
Expenses from a natural disaster or other unexpected event
Use a Multi-Year Average
To account for year-to-year fluctuations and provide a more stable picture of the business’s earning potential, consider using a 3-year average for your SDE calculation. This approach can help smooth out anomalies and provide a more reliable figure for valuation purposes.
Document and Justify All Add-Backs
Thorough documentation is crucial when calculating SDE. For each add-back, maintain clear records and be prepared to explain your reasoning. This transparency will build trust with potential buyers and facilitate smoother negotiations.
Best practices for documentation:
Create a detailed schedule of all add-backs
Include explanations for each item
Provide supporting documentation where possible
Consider Industry-Specific Factors
Different industries may have unique considerations when calculating SDE. For example, some industries may have standard practices for treating certain expenses or calculating owner compensation. Research industry norms or consult with an industry expert to ensure your SDE calculation aligns with sector standards.
Be Conservative in Your Calculations
While it’s important to accurately represent your business’s earning potential, it’s generally better to err on the side of caution when calculating SDE. Overly aggressive add-backs can raise red flags for potential buyers and may lead to difficulties during due diligence.
Use SDE in Conjunction with Other Valuation Methods
While SDE is a valuable metric, it shouldn’t be the only factor considered in valuing a business. Use it alongside other valuation methods such as:
Comparable company analysis
Discounted cash flow analysis
Asset-based valuation
This multi-faceted approach provides a more comprehensive picture of your business’s value.
Regularly Update Your Seller’s Discretionary Earnings
Calculation
Don’t wait until you’re ready to sell to calculate your SDE. Make it a practice to update your SDE calculation regularly, perhaps annually or semi-annually. This ongoing process can help you:
Identify trends in your business’s performance
Spot areas where you can improve profitability
Be prepared if an unexpected sale opportunity arises
Be Prepared for Due Diligence
Remember that your SDE calculation will be scrutinized during the due diligence process if you decide to sell. Be prepared to defend your calculations and provide additional information as needed.
Tips for due diligence preparation:
Organize all supporting documentation
Be transparent about your calculation methods
Be ready to explain any unusual items or trends
By following these best practices, you can calculate a more accurate SDE that truly represents your business’s earning potential. This not only helps establish a fair valuation but also builds trust with potential buyers, facilitating smoother negotiations during a sale process. Remember, the goal is not to inflate your business’s value artificially, but to present a clear, honest, and comprehensive picture of its financial performance and potential.
Don’t DIY—hiring a professional to handle Seller’s Discretionary Earnings (SDE) calculations is often a small investment compared to the overall cost of your acquisition or sale
It’s important to note that calculating SDE accurately often requires the expertise of a financial professional or business broker. They can help ensure all appropriate add-backs are included and the calculation aligns with industry standards. Remember, the goal of calculating SDE is to present the true earning potential of your business to potential buyers. A clear and accurate SDE calculation can significantly impact your business’s perceived value and attractiveness to potential purchasers. Call us today for more information.
