Seller’s Discretionary Earnings Explained Without the Accounting Jargon

What Exactly Is Seller’s Discretionary Earnings?

Seller’s Discretionary Earnings is commonly used when valuing smaller, owner-operated businesses. The basic idea is straightforward. Start with the company’s net profit, then add back certain expenses that a new owner may not have to incur.

Those adjustments can include the owner’s salary, payroll taxes related to that salary, certain personal expenses paid through the business, interest, depreciation, amortization, and legitimate one-time or nonrecurring expenses.

For example, assume a business reports $150,000 in net income. The owner also receives a $100,000 salary, runs $12,000 of personal vehicle expenses through the company, and spent $8,000 on a one-time legal matter.

After reasonable adjustments, the SDE might be approximately $270,000.

That number gives a buyer a better sense of the total economic benefit available to an owner-operator.

Why Not Just Use Net Income?

Because net income does not always tell the whole story.

Two similar businesses may report very different profits simply because their owners handle expenses differently. One owner may pay himself a large salary. Another may take a smaller salary and more distributions. One may have a company car. Another may drive a 2008 sedan with a dashboard light that has been on since the Obama administration.

SDE attempts to normalize those differences. It allows buyers to look past certain owner-specific decisions and focus on the underlying financial performance of the business. That is particularly important in privately held companies where the financial statements are often prepared primarily for tax purposes rather than for a future buyer.

What Can Be Added Back?

This is where sellers sometimes become a little too enthusiastic.

Not every expense is an add-back. A legitimate add-back is generally an expense that is personal to the current owner, nonrecurring, or not expected to continue under new ownership.

Common examples may include:

• One working owner’s salary and related payroll taxes

• Personal vehicle expenses paid by the business

• Personal travel or entertainment expenses

• Certain family members on payroll who do not perform necessary work

• One-time legal or consulting expenses

• Unusual repair costs

• Depreciation and amortization

• Interest expense

The key word is reasonable. If the company needs the expense to operate, it probably should not disappear simply because the business is for sale.

You cannot add back the bookkeeper because you hope the buyer enjoys QuickBooks. You cannot eliminate normal marketing expenses because the new owner can “figure something out.” And you cannot add back every repair bill simply because you would prefer that nothing ever break again.

Buyers and lenders tend to notice these things.

Documentation Matters

An add-back is only as convincing as the documentation behind it. If you claim that $25,000 of expenses were personal, be prepared to show exactly where those expenses appear in the financial statements and why they will not continue.

Good documentation builds credibility. Weak documentation creates doubt. And once buyers start questioning one adjustment, they often begin questioning the others.

This is why clean financial records are so important before going to market. Ideally, a seller should work with an accountant and experienced business broker to identify reasonable adjustments and prepare a clear SDE schedule. The goal is not to inflate the number. The goal is to present the company’s true earning power in a way that can survive buyer scrutiny.

How Buyers Use SDE

In many small business transactions, buyers use SDE as a starting point for valuation. A market multiple is often applied to the company’s SDE, with the actual multiple depending on factors such as industry, size, growth, customer concentration, management structure, recurring revenue, competition, and overall risk.

That means two companies with identical SDE can still have very different values.

A business with strong systems, diversified customers, stable employees, and consistent growth will usually be viewed more favorably than one where the owner handles everything and the largest customer accounts for half the revenue.

SDE tells us how much the business earns. It does not tell us how risky those earnings are.

Know Your Real Number Before You Sell

Understanding SDE before you enter the market can help you set realistic expectations, improve your financial presentation, and identify opportunities to increase value.

It can also save you from the unpleasant experience of discovering during negotiations that your version of earnings and the buyer’s version live in different zip codes.

A professional valuation or broker opinion of value should include a careful review of the financial statements, tax returns, and proposed adjustments. The sooner you understand your company’s true SDE, the more time you have to improve it.

And when it comes to selling a business, a well-supported number is always more valuable than an optimistic one.