If you are going to sell a business or buy a business, it is important to understand Seller’s Discretionary Earnings and how it is used to value a business. In most small business sales, the seller is operating the business and the buyer plans to do likewise. Because of this, the best measure of the earning power of the business is the total income and benefits available to the owner, not the reported net profit of the business. In most small businesses, the owner is not trying to maximize net profit. The owner is trying to take out as much as possible in tax deductible salary and benefits. When buying or selling an owner-operated business, it is important to understand, and know, the Seller’s Discretionary Earnings (SDE) of the business. This is the best measure of the earning power of a small business.
Seller’s Discretionary Earnings is defined as net income before deducting the primary owner’s compensation and benefits, other discretionary, non-operating, or non-recurring income or expense, depreciation, interest, and taxes. This is also referred to as Owner’s Cash Flow. This is the amount of money available to pay the buyer an income, pay off debt, and provide for capital to operate the business. In order to accurately calculate SDE, the broker will rely on tax returns, income statements, and other financial records.
SDE includes owner compensation. Discretionary expenses and perks, such as the owner’s company automobile, personal travel, meals and entertainment, and the owner’s health insurance, are also included. Interest expense is added back because the buyer is generally not assuming the debt of the business. Depreciation and amortization are added back because they are not cash expenses, however, if it is necessary to replace equipment within the next year that expense is deducted. Taxes are added back because a new owner may have a different tax expense. Additional adjustments are made for non-recurring expenses or income like one-time legal fees or the sale of a business asset. Non-operating income and expense are adjusted out also.
In order for an expense to be considered discretionary, it must meet certain criteria:
- The expense must be for the benefit of the owner (like health insurance)
- The expense cannot benefit the business or the employees
- The expense must be documented on tax returns and P&Ls
- The expense must be verifiable as discretionary by a potential buyer
Counting meals and entertainment that gain the business new clients or counting auto expenses when the automobile was used to conduct business are not allowed. To pass due diligence, it is important to count only verifiable discretionary expenses.
SDE and Business Valuation
The “Market Approach” is an accepted method of valuing a business. In this method, the appraiser estimates the selling price of the business. There are databases of actual business sales which show what comparable businesses have sold for as a multiple of revenue and SDE. These multiples are applied to the financials of the business being appraised to arrive at an estimated selling price.
Get a Business Valuation from BayState Business Brokers
BayState Business Brokers offers a business appraisal using the market approach. The cost is modest and there is no obligation. If you are considering selling your business, contact us today to schedule a business valuation.