What are Seller’s Discretionary Earnings?

01 Mar What are Seller’s Discretionary Earnings?

The first step in figuring out the value of a business is determining Seller’s Discretionary Earnings (often referred to as SDE).  So, what is SDE and how is it calculated?

Sellers Discretionary Earnings can simply be defined as the complete owner benefit that a business produces.

Seller’s Discretionary Earnings (SDE) is calculated by adding the sum of the net income before taxes; interest; depreciation and amortization; owner’s compensation; owner’s benefits; and non-recurring expenses.

Let’s look at each of the above items in further detail to further drill down into what makes up SDE.

Net Income Before Taxes – otherwise referred to as operating income, this is the bottom line.  What is left over after all expenses are subtracted from the sales, prior to the payment of any income taxes.

Interest – when we value a small business we assume that the business is going to be purchased for cash without liability (meaning zero debt), so if there is any interest the new owner will not be paying it.  Thus it gets added back to increase the owner’s benefit.

Depreciation and Amortization – both non-cash expenses that are deducted for taxation purposes.

Owner’s Compensation – Any monies paid to the owner such as a salary (along with their share of payroll taxes) bonuses and draws.

Owner’s Benefits – This is the category where things start to get interesting.  There are many tax advantages to owning a small business and this is where they show up.  Often seen examples are health/medical insurance for the owner/owner’s family, cell phones, retirement contributions, meals and entertainment, vehicle expenses, and travel expenses.

Non- Recurring Expenses – Expenses that are one time in nature and should not be accounted for annually.  A very basic non-recurring expense would be a broken window.  Window’s very rarely break during the course of most businesses activities and if one does we shouldn’t assuming that will be an ongoing annual expense.

Now let’s look at the above in a real-world example:

What we see above is common for most small business and shows why we need to calculate SDE.  Although this make believe business shows a rather anemic bottom line of less than $5,000, the owner is actually seeing a benefit of over $100,000.