Seller’s Discretionary Earnings (SDE) Valuation | Selling a Business in California
A seller’s discretionary earnings (SDE) is a seller’s net income before taxes, interest, depreciation, and amortization plus certain other discretionary expenses like the owner’s salary, benefits, and personal automobile expenses. The seller’s discretionary earnings worksheet provides a detailed breakdown of how SDE is calculated. The seller’s discretionary earnings multiple is used to value a business based on its ability to generate income for its owners.
Businesses with high SDE multiples are typically more valuable than businesses with low SDE multiples.
In this valuation post, we’ll walk you through the SDE calculation to properly value your business before putting it for sale.
Calculate the Seller’s Discretionary Earnings
We start with the seller’s net income before taxes (NIBT). Then add back in any interest expense, depreciation expense, and amortization expense. Next, add in any other discretionary expenses like the owner’s salary, benefits, and personal automobile expenses. Finally, divide the total by the number of days in the year. This will give you the seller’s discretionary earnings per day.
A seller’s discretionary earnings can be an important factor in valuing a business, a wholesale distribution company for example. If a business has a high SDE, it is typically more valuable than a business with a low SDE. When calculating the value of a business that is under $1 million in value, be sure to use a seller’s discretionary earnings to maximize your company’s business value.
Seller’s Discretionary Earnings Worksheet: SDE vs EBITDA
SDE stands for Seller’s Discretionary Earnings, while EBITDA means Earnings Before Interest, Taxes, Depreciation, Amortization. These are calculations used to determine the value of a business.
SDE measures the potential revenue of a business. This provides insight into a business’s value by calculating the owner’s discretionary earnings, like salary, benefits, and depreciation assets. The typical expenses included when calculating SDE are net income, interest, depreciation, amortization, and the owner’s total current compensation.
Since SDE adds back expenses not needed for business operation, the owner’s total compensation, and non-recurring expenses, it can provide buyers an accurate insight into the potential future profit.
We will illustrate how to calculate SDE for a business, which we call Business A.
- Net income: $80,000
- Interest income: $100
- Interest expense: $750
- Taxes: $18,350
- Depreciation: $2,160
- Amortization: $400
- Non-recurring expenses: $77
- Owner’s compensation: $68,000
- Personal expenses: $325
Adding it all up ($80,000 + $100 + $750 + $18,350 + $2,160 + $400 + $77 + $68,000 + $325) we get an SDE of $170,162. Businesses with a high SDE mean that buyers will pay a higher multiple. For the example above, Business A’s SDE is over $150,000, so buyers are willing to pay multiples of 2 to 4.
Those less than $150,000 may see multiples of 1.5-2.5, and those greater than $500,000 can expect a price in multiples of 4 to 5. An SDE surpassing the $1,000,000 threshold will usually calculate the business value with EBITDA. However, the multiples vary from industry to industry.
EBITDA calculates business value using the same expenses as SDE minus the owner’s salary. While sellers could determine their businesses worth using only cash revenue, EBITDA goes a step further by providing buyers insight into potential expenses they may incur later on.
For example, as opposed to only cash revenue, if a business invests in growth expenditures, it should use EBITDA to provide a more appealing business value number.
EBITDA uses the same gain and loss numbers as SDE. Those are net income, taxes, income, depreciation, and amortization. However, calculating EBITDA does not include adding the owner’s yearly compensations. There are two variations of EBITDA: normalized EBITDA and adjusted EBITDA.
The Adjusted EBITDA takes the number from the unadjusted EBITDA and adds or subtracts values like start-up costs, litigation costs, donations, investments, and other business operation expenses. EBITDA adjustments vary from business to business, but they can help normalize the outcome amount for their EBITDA.
EBITDA adjustments are helpful when a business incurs a hefty expense, like investments or hiring costs that weaken normalized EBITDA. Adjusted EBITDA is also better for buyers to compare the number with other companies in the same industry. See EBITDA multiples of trucking companies.
You may be wondering, What is a good EBITDA?” Well, according to Forbes, businesses with an adjusted EBITDA higher than their normalized EBITDA show buyers that the business is healthy and seeing growth. Here’s an adjusted EBITDA example on how to calculate adjusted EBITDA from normalized EBITDA using Company B:
- Net income: $1,500,000
- Taxes: $10,500
- Interest: $7,500
- Depreciation & Amortization: $15,150
After adding it all up ($1,500,000 + 10,500 + $7,500 + $15,150), we get an EBITDA of $1,533,150.
With adjusted EBITDA, Company B’s new value will look like this:
- EBITDA: $1,533,150
- Goodwill impairments: $18,000
- Excess owner’s salary: $60,000
- Non-recurring legal expenses: $19,000
- Gain on asset disposal: $13,500
After adding Company B’s list of EBITDA adjustments ($1,533,150 + $18,000 + $60,000 + $19,000 – $13,5000), Company B’s adjusted EBITDA is $1,643,650.
Seller’s Discretionary Earnings: Owner Salary Add-Backs
Seller’s Discretionary Earnings (SDE) is a measure of a company’s adjusted income and financial statements. It takes into account various necessary and discretionary expenses, such as the owner’s salary, that are necessary to run the business.
There are several key components to the SDE Adjustments:
1. Owner’s Salary: This is the most important component of SDE. It represents the compensation that an owner would pay themselves if they were not running the business. This amount is added back to adjusted income to get SDE.
2. Depreciation and Amortization: These expenses are added back to adjusted income to get SDE because they are non-cash expenses.
3. Interest Expense: This expense is added back to adjusted income to get SDE because it is a tax deduction.
4. Other Add-Backs: There may be other expenses that the seller considers necessary to run the business that is not included in the above categories. These can be added back to adjusted income at the seller’s discretion to get SDE.
How To Maximise A Business Value Before Listing It For Sale?
When it comes time to sell a business, maximizing its value is of paramount importance. There are a number of ways to do this, but one of the most important is to ensure that the seller’s discretionary earnings are as high as possible.
This is the adjusted income that is left over after all expenses have been paid, and it gives potential buyers a clear indication of the profitability of the business. By increasing the seller’s discretionary earnings, you can significantly increase the business value before listing it for sale.
Another way to maximize value is to reduce expenses wherever possible. This includes both one-time costs like marketing and advertising and recurring costs like rent and utilities. By lowering expenses, you’ll be able to show potential buyers that the business is more profitable than they may have initially thought.
Finally, it’s also important to focus on growth when preparing to sell a business. This could mean expanding into new markets or product lines or simply increasing sales to existing customers.
By demonstrating that the business is growing, you can further increase its value in the eyes of potential buyers. Taking these steps will help you maximize the value of your business before listing it for sale.
If you’re concerned about how to price a business for sale or want to maximize business value before preparing a business for sale, consider using an experienced professional to help you with positioning your company for the highest evaluation.
If you’re looking to get a proper business valuation for your company in California, the Seller’s Discretionary Earnings calculation, or SDE, is your best bet. This methodology is specifically designed for businesses with a value of less than $1 million. By understanding and properly valuing your business using this metric, you can be sure that you’re getting the most out of your hard work. See how to value a construction company if your business is in the construction industry niche.
Have questions about how to calculate Seller’s Discretionary Earnings? Our team is here to help. Contact us today to learn more and get started on increasing the value of your business.
If you would like more information on the process of selling a business, be sure to check out our website. Here, you’ll find tips and advice on how to sell your business as well as case studies of past transactions. You can also download our free guide on what to do when selling a business.
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