Introduction:
Understanding Seller’s Discretionary Earnings: If you have ever purchased or sold a small company, you’ve probably heard the term “Seller’s Discretionary Earnings”. You could be thinking “Earnings are discretionary? My earnings aren’t discretionary!” Let’s examine this often-misunderstood term, and how it compares to EBITDA, another common earnings measure. These are important factors in doing a business valuation and vital to understand when venturing into the M&A space.
What is Seller’s Discretionary Earnings?
Seller’s Discretionary Earnings (“SDE”) is a calculation of the total financial benefit that a single full time owner-operator would derive from a business on an annual basis. It is also referred to as Adjusted Cash Flow, Total Owner’s Benefit or Seller’s Discretionary Cash Flow. Here at HP we prefer the term Discretionary Earnings (DE). For this blog we’ll use the more common definition of SDE. SDE is most often used in the valuation and sale of established businesses. This type of business often refers to owner-operated companies with less than $5 million of revenue. Larger businesses primarily use EBITDA (not SDE).
SDE vs EBITDA
SDE = Adjusted EBITDA + Owner Compensation
where EBITDA = net Earnings + Interest + Taxes + Depreciation/Amortization.
Seller’s Discretionary Earnings is always a larger number than EBITDA. This is counter-intuitive for people used to working in middle market M&A. They usually think of EBITDA as the large number that items are subtracted from to calculate net cash flow. Let’s look at the formula.
When applying price multiples for sale or valuation purposes it’s important to accurately differentiate between SDE and EBITDA. A mismatch between the earnings measure used and the multiple applied can result in significantly overvaluing or undervaluing a business.
SDE provides a more accurate picture of a business’s cash flow and profitability from the owner’s perspective. EBITDA is often used by larger businesses, investors, and analysts to assess a company’s financial performance and compare it to industry peers. By understanding the differences between SDE and EBITDA, business owners, investors, and financial professionals can choose the most relevant metric for their specific needs and make more informed decisions.
Normalization Adjustments
Once we calculate EBITDA (or SDE) from a company’s profit and loss statement, we must work through normalizing adjustments. We often break normalizing adjustments into two categories: discretionary items and non-recurring items.
Discretionary Items
Discretionary expenses are those that the business paid for but can provide a personal benefit to the owner. These expenses exist because owners want the “tax benefit” of expensing them. But they also want the benefit of adding them back into earnings when it comes time to value and sell the business.
Typical discretionary expenses are owner medical or life insurance, personal travel, automobiles, meals/entertainment, and social clubs. To qualify as discretionary, each expense must meet all three of these criteria:
1.Benefit the owner(s)
2.Not benefit the business or its employees
3.Are paid for by the business and expensed on tax returns and P&Ls.
Whether an expense is discretionary or not may not be obvious:
| Definitely Adjust | Don’t Adjust | Gray Areas |
|---|---|---|
| Retirement plan contributions | Networking group memberships | Travel (business and pleasure) |
| Home landscaping | Marketing expenses | Contributions |
Discretionary expenses are often the subject of debate between a buyer and seller. Buyers, of course, are risk averse and dubious about all these co-mingled expenses the seller claims are “not real business expenses.” Items that fall in the grey area will require extra documentation by the seller and due diligence by the buyer. Certain items that a buyer might accept won’t be accepted by a bank. Generally speaking, sellers will benefit from not commingling business and personal expenses.
Non-Recurring Items
The other major category to examine is extraordinary/one time income or expenses. Adjusting for extraordinary one-time income and expenses makes sense because they are not expenses that are indicative of the core business operations. Common examples are restructuring costs, costs related to acts of nature, asset sales, litigation expense and emergency repair costs. One-time expenses are scrutinized. Did that bad debt only happen once? Or is it likely to occur again?
Why is this important?
In M&A transactions buyers are concerned about risks: What aren’t you telling them? How could this investment go bad? We often say that getting to a closing is about removing roadblocks in the deal – and often the biggest among them is reducing the buyer’s level of perceived risk. With that in mind it’s important to think about the line items that go into SDE well before you go to market and do your best to reduce any areas that might fall into the “questionable” area. The cleaner your financials are the more likely you are to sell for the best price and terms.
Understanding Seller’s Discretionary Earnings www.hpaccounting.com
https://www.expertinstitute.com/resources/insights/using-expert-witnesses-to-calculate-or-prove-damages/ https://hpaccounting.com/the-difference-between-an-officer-and-a-director