Seller’s discretionary earnings (SDE) is a measure of the earnings of a business and is the most common measure of cash flow used to value a small business. SDE allows a buyer to quickly compare two companies for valuation purposes.
SDE is defined as:
- Pre-tax net income: This is the bottom-line profit that appears on the P&L statements; plus
- Owner’s compensation paid to all owners, less the cost needed to replace a second or third owner; plus
- Interest expense; plus
- Depreciation and amortization; plus
- Discretionary expenses (auto, cell phone, meals, entertainment, travel, etc.); plus
- Adjustments for extraordinary, non-operating revenue or expenses, non-recurring expenses or revenue (lawsuit, flood damage, etc.)
Most valuation methods are based on a multiple of earnings, and SDE is the most common definition of earnings for small businesses. Once you know the SDE of a business, you apply a multiple to arrive at the value of the business.
That’s the Cliff’s Notes version of SDE. Read on for a complete overview of SDE.
- SDE meaning
- Sample Seller’s Discretionary Earnings (SDE) Calculation
- What is SDE?
- What does SDE stand for?
- SDE Business
- What does SDE stand for in business?
- How is SDE calculated?
- Does SDE include owners salary?
Table of Contents
- Why SDE?
- Sample Seller’s Discretionary Earnings (SDE) Calculation
- Benefits of SDE
- Downsides of SDE
- How to Increase the Value of Your Business
- FAQs about Seller’s Discretionary Earnings (SDE)
There is one primary reason buyers use SDE: To quickly compare two businesses with one another.
- SDE is a rule of thumb. It is an approximate measure of cash flow available to the buyer. The goal of calculating SDE is to make an apples-to-apples comparison between businesses. SDE facilitates comparisons across companies, whether they are in the same industry or not.
- SDE is a rough estimate of free cash flow — an estimate of the amount of cash flow available to pay back interest or debt and fund the purchase of new equipment (i.e., capital expenditures or CapEx). Once SDE is calculated, buyers will dig deeper into a multitude of other factors, such as the growth rate of the company, gross margins, customer concentration, and hundreds of additional financial and non-financial factors.
- SDE is primarily used at the outset as a measure of earnings when a buyer is initially evaluating a company as an acquisition target.
- SDE is used both in income-based and market-based valuation methods. For example, SDE is used to calculate the value of a business using a multiple in several income-based valuation methods. It is also used to compare multiples among similar businesses that recently sold (i.e., comparable transactions).
This article covers the following:
- If SDE is not an accurate measure of cash flow, why is it the most popular measure of cash flow for valuing a small business?
- Are any other measures of earnings used by buyers? If so, what are they and how can different measures of earnings affect the value of my business?
- Should I use SDE to value my business? Or should I use another metric?
- How do I calculate SDE for my business?
- What are the benefits of SDE? Does SDE ignore any important factors that buyers may take into consideration?
- What are the major downsides of SDE? Is SDE an accurate measure of cash flow?
- What other metrics do buyers use instead of SDE?
- Is SDE the same as cash flow?
- How can I increase the value of my business?
Sample Seller’s Discretionary Earnings (SDE) Calculation
|Pre-Tax net income; plus
|Owner’s compensation; plus
|Discretionary expenses; plus
|Extraordinary, non-operating, non-recurring expenses
|Seller’s Discretionary Earnings (SDE) =
Benefits of SDE
- Commonly Used: SDE is the most commonly used measure of earnings by buyers, sellers, business brokers, and every other party for small businesses.
- Straightforward Calculation: SDE is simple to calculate and less prone to error, thereby facilitating comparisons.
- Eliminates Non-Operating Variables: SDE eliminates variables that may not impact the buyer post-acquisition, such as interest or taxes. It also removes non-cash expenses (i.e., depreciation & amortization). That’s so buyers can make their own estimates regarding the amount of these expenses and then deduct the amount from cash flow based on when the money is actually expended, not when it is deducted for tax purposes.
- Allows Comparisons: Because SDE is commonly used and straightforward to calculate, it allows one to easily compare a business’s earnings to other businesses. This comparison also facilitates the use of comparable transactions to value a business.
Downsides of SDE
SDE is a Rule of Thumb: SDE is a simple rule of thumb. Expect buyers to dig deeper into your financials. SDE is not a magic bullet — a high SDE does not necessarily mean that your business will be an attractive acquisition candidate to a buyer.
SDE is Not an Accurate Measure of Actual Cash Flow: SDE is not a wholly accurate measure of cash flow for a buyer post-acquisition for the following reasons:
- Depreciation: Adding back depreciation for companies with significant depreciation and ongoing capital expenditures results is an inflated measure of earnings. SDE is misleading for companies with significant fixed (depreciable) assets.
- Amortization: The same can be said for amortization, as in the case of companies with significant amortizable intellectual property (e.g., pharmaceutical companies). However, this is less common in small businesses.
- Working Capital: SDE ignores working capital needs by not accounting for working capital injections that might be required by the buyer, especially in the case of high-growth companies.
- Taxes: SDE also ignores the impact of income taxes.
How to Increase the Value of Your Business
While you should not ignore other factors, one of your most important focuses should be on increasing SDE. Every dollar increase in SDE increases the value of your business by its multiple.
For example, let’s say your business is likely to sell at a 3.0 multiple. If you increase your SDE by $100,000 per year, you have increased the value of your business by $400,000 ($100,000 x 4.0 multiple = $400,000).
There are only two ways to increase SDE:
- Increase Sales:
- The easiest way to increase sales is to increase your prices since 100% of your price increase will fall to the bottom line. For example, if your company currently generates $2 million per year in revenue and you increase pricing by 5%, your SDE will increase by $100,000 per year ($2 million x 5% = $100,000). If your current SDE is $400,000, your SDE will increase by 25% (from $400,000 to $500,000). In essence, a 5% rise in prices increases your SDE by 25%.
- Other methods for increasing sales primarily include creating new products or services, or selling more of your existing products and services. However, be careful before engaging in risky product development or marketing campaigns if you plan on selling in the next few years. Conservative buyers will generally not allow you to make adjustments for any marketing campaigns or product launches that were unsuccessful when calculating SDE. We recommend sticking to low-risk methods of increasing your sales if you plan on selling in the next three years, such as increasing your budget in predictable marketing campaigns with measurable returns. Avoid high-risk sales or marketing strategies such as hiring a new sales manager or launching a new marketing campaign in which you have no experience. Such strategies can drain cash flow, which decreases SDE and therefore decreases the value of your business.
- Decrease Expenses: Decreasing your expenses is often easier than increasing revenue. It also has the advantage of having an immediate impact on SDE and is less risky than attempting to increase revenue. The only caveat here is to not reduce expenses that the buyer would view as unfavorable — standard insurance premiums should be maintained, for example, as should normal inventory levels.
Another alternative for increasing the value of your business is to increase its growth rate so that “projected SDE” is used to value your business instead of “current year’s SDE.”
The value of your business is normally based on its most recent 12-month SDE (trailing twelve months, or TTM). However, if you have demonstrated strong and consistent growth, you may be able to negotiate a price based on some measure of projected SDE.
FAQs About Seller’s Discretionary Earnings (SDE)
What other metrics are similar to SDE?
- LTM SDE = Last twelve months (LTM)
- TTM SDE = Trailing twelve months (TTM)
- EBITDA = Earnings before interest, taxes, depreciation, and amortization.
- EBIT = Earnings Before Interest and Taxes, also called “Operating Profit.” EBITDA can be calculated by adding Operating Profit + Depreciation + Amortization. However, this is not used for most small to mid-sized companies.
Which year’s SDE should my valuation be based on?
A valuation is normally based on the last full year’s SDE or trailing twelve months (TTM). In other cases, a weighted average may be used if results are inconsistent from year to year and business cycles are longer and predictable.
Some value may also be placed on projected current year SDE if the growth rate is consistent and predictable. Some buyers may attempt to use an average of the last three year’s SDE, which can pull down the valuation if the business is growing consistently.
Is SDE the same as cash flow?
No, they are entirely different concepts. Your cash flow can be determined by your “cash flow statement” or “statement of cash flows.”
Many small businesses, unfortunately, do not prepare a cash flow statement or know how to read one. “Cash flow” as a term is used loosely in the industry and you should always ask for a definition whenever someone uses it.
SDE is not the only metric used to value small businesses. Every buyer will take dozens of factors into consideration when valuing your company.
Those factors include customer concentration, growth rates, brand awareness, systems, processes, margins, working capital requirements, amount of recurring revenue and availability of financing, among others.