Seller’s Discretionary Earnings (SDE) | Definition & Examples

Executive Summary

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, such as auto, cell phone, meals, entertainment, and travel, plus
• Adjustments for extraordinary, non-operating revenue or expenses, and non-recurring expenses or revenue, such as lawsuits, flood damage, etc.

Most valuation methods are based on a multiple of earnings. Once you know the SDE of a small business, you can apply a multiple to arrive at the business’s value.

Introduction

SDE is the most common metric used to value small businesses. But what is SDE? How is it calculated, and when should it be used?

In this article, we’ll discover just how accurate SDE is, how different measures of earnings can affect your business valuation, and whether SDE ignores any important factors that buyers may take into account.

Finally, we tackle the ultimate question of any valuation – what can you do to increase the value of your business?

Definition of SDE

What does SDE stand for? 

SDE stands for seller’s discretionary earnings. 

What is the definition and purpose of SDE?

Seller’s discretionary earnings (SDE) is a measure of a business’s earnings and is the most common measure of cash flow used to value a small business. SDE allows a buyer to compare two companies for valuation purposes.

SDE is defined as:

• Pre-tax net income, 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, such as auto, cell phone, meals, entertainment, and travel, plus
  • Adjustments for extraordinary, non-operating revenue or expenses, and non-recurring expenses or revenue, such as lawsuits, flood damage, etc.

Does SDE include the owner’s salary?

Yes, the owner’s salary is included as an adjustment when calculating SDE.

Reasons To Use SDE

There is one primary reason buyers use SDE – to quickly compare two businesses.

Why Use SDE
SDE Is a Rule of Thumb	It’s 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, whether they’re in the same industry or not.
SDE Is an Estimate of Free Cash Flow	SDE is 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 Used as a Measure of Earnings	When a buyer is initially evaluating a company as a target acquisition, SDE provides an approximate measure of earnings.
SDE Is Used in Valuation Methods	SDE is used to calculate business value in several income-based and market-based valuation methods. It’s also used to compare multiples among similar businesses that recently sold (i.e., comparable transactions).

Sample Seller’s Discretionary Earnings (SDE) Calculation

Benefits of SDE

The following are the primary benefits of using 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.
• 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’s deducted for tax purposes.
• Allows Comparisons: Because SDE is commonly used and straightforward to calculate, it allows parties to compare business earnings to other businesses. This comparison also facilitates the use of comparable transactions to value a business.

Downsides of SDE

The following are the primary downsides of using SDE:

• SDE Is a Rule of Thumb: It’s not a magic bullet – a high SDE doesn’t always mean your business will be an attractive acquisition candidate to a buyer. Expect buyers to dig deeper into your financials. 
• SDE Is Not an Accurate Measure of 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 in an inflated measure of earnings. SDE is misleading for companies with significant fixed (i.e., depreciable) assets.
  • Amortization: The same can be said for amortization, as in companies with significant amortizable intellectual property (e.g., pharmaceutical companies). 
  • Working Capital: SDE ignores 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 shouldn’t ignore other factors, one way to increase the value of your business is to increase SDE. Every dollar increase in SDE adds to the value of your business by its multiple.

For example, let’s say your business is likely to sell at a 4.0 multiple. If you increase your SDE by $100,000 per year, you’ve increased the value of your business by $400,000 ($100,000 x 4.0 multiple = $400,000).

Two Primary Methods for Increasing Value

There are only two ways to increase SDE:

1. 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 (less merchant fees, generally speaking). 

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). So, a 5% rise in prices increases your SDE by 25%. 

Other methods for increasing sales include creating new products or services or selling more of them. But be careful – when calculating SDE, conservative buyers will generally not allow adjustments for any recent campaigns or launches that were unsuccessful.

You can increase the value of your business by increasing SDE. Every dollar increase in SDE adds to the value of your business by its multiple.

If you plan on selling in the next three years, stick to low-risk methods of increasing your sales, such as predictable marketing with measurable returns. Avoid high-risk strategies such as hiring a new sales manager or launching new campaigns outside of your expertise. These can drain cash flow, which decreases SDE and, therefore, the value of your business.

2. Decrease Expenses

Decreasing your expenses is often easier than increasing revenue. It’s also less risky and has an immediate impact on SDE. The only caveat here is that you don’t want to reduce expenses the buyer would view as favorable – standard insurance premiums should be maintained, for example, as should normal inventory levels.

Other Ways To Increase the Value of Your Business

Another alternative for increasing the value of your business is to increase its growth rate. 

The value of your business is normally based on its most recent 12-month SDE, which is called the trailing twelve months (TTM). But, if you’ve demonstrated strong and consistent growth, you may be able to negotiate a price based on some measure of “projected SDE” rather than the current year’s SDE.

FAQs About SDE

What other metrics are similar to SDE?

• LTM: last twelve months SDE
• TTM: trailing twelve months SDE
• EBITDA: earnings before interest, taxes, depreciation, and amortization
• EBIT*: earnings before interest and taxes, also called Operating Profit.

*Operating Profit + Depreciation + Amortization can generate EBITDA, but this method 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 some cases, a weighted average may be used if results are inconsistent from year to year and business cycles are longer and predictable.

If the growth rate is consistent and predictable, some value may be placed on the projected current-year SDE. 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’re entirely different concepts. 

That said, the term “cash flow” is used loosely in the industry, and some may use it to refer to EBITDA. You should always ask for a definition whenever someone speaks of cash flow. 

Your cash flow can be determined by your “cash flow statement” or “statement of cash flows,” which are more likely prepared by mid-market businesses than small ones. 

Conclusion

SDE isn’t the only metric used to value small businesses. Buyers 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.

If your SDE draws significant heat from your valuation, then boost your sales, scale back your expenses, increase your growth rate, and revisit SDE when the timing is better.