What is Seller’s Discretionary Earnings (SDE)?
Seller’s Discretionary Earnings (SDE) measures the normalized, operating profitability of small to mid-sized businesses (SMBs).
Conceptually, SDE represents the earnings of a small business before income taxes, non-operating income and expenses, owner’s compensation, non-cash add backs (depreciation and amortization), interest expense or income, and non-recurring items, including personal expenses.
What is the Definition of Seller’s Discretionary Earnings?
SDE stands for “Seller’s Discretionary Earnings” in business and reflects the normalized profits that a company, most often a small business, generated on behalf of its owner across a given period.
The seller’s discretionary earnings (SDE) metric is intended to be a quick approximation of a SMB’s free cash flow (FCF).
In practice, the SDE metric is most prevalent under the context of M&A for small to mid-sized businesses (SMBs), where a prospective buyer conducts diligence on the target SMB to determine the merits and risks of the potential investment.
Therefore, the seller’s discretionary earnings (SDE) metric estimates the monetary benefits that a business has generated on behalf of the owner to date.
How to Calculate SDE?
The calculation of the seller’s discretionary earnings (SDE) metric can be broken down into the following step-by-step process:
- Determine Pre-Tax Income (EBT) → The pre-tax income (EBT) is the starting point and represents the total earnings inclusive of all costs, except for the income taxes owed to the government.
- Normalize Owner’s Salary (Including Payroll Taxes) → The owner’s salary component is oftentimes the owner’s desired level of compensation, rather than the market rate, i.e. there can be substantial deviation between the current salary vs. the salary post-acquisition. So, SDE reduces the owner salary to the market rate, at which the prior owner (or his/her replacement) would earn performing the same job function. Hence, the adjustment removes any “excess” compensation paid to the owner.
- Add Back Non-Cash Expenses (D&A) → Depreciation expense is meant to allocate the cost of purchasing long-term, tangible assets, such as equipment, buildings and machinery, across the expected useful life assumption. However, the actual cash outlay (“outflow”) occurred on the date of original purchase, i.e. the capital expenditure (Capex). Like depreciation, amortization reduces the carrying value of long-term assets, but the distinction is that amortization pertains to intangible assets, such as patents and intellectual property (IPO).
- Add Back Interest Expense, net → From the perspective of the borrower, the interest expense reflects the cost of debt financing, where the risk is priced into the interest rate (and thus interest expense). The intuition behind the interest expense add-back is to remove discretionary financing decisions by the current management team. The new owner will run the company under a different capitalization, i.e. the percent mix of debt and equity financing used to fund operations, so the current capital structure should not impact the pro forma (“forward looking”) forecast.
- Add Back Non-Recurring Expenses → Non-recurring items are one-time, extraordinary expenses that are not expected to continue into the foreseeable future (e.g. Legal and Consulting Professional Fees, Transaction Advisory Fees, “Bad Debt”)
- Add Back Discretionary Expenses → Discretionary expenses are non-operating expenses NOT directly tied to the core operations of the business, such as personal travel costs, health insurance, meal and entertainment expenses, charitable contributions, owner “perks”, etc. Since discretionary expenses are not part of the company’s core operations – which SDE attempts to measure – those expenses must be added back to portray a more accurate picture of the company’s historical profitability, which is referenced to guide forecast models.
The seller’s discretionary earnings (SDE) profit metric reflects the normalized earnings of a SMB prior to the owner’s salary, interest, income taxes and non-cash expenses, such as depreciation and amortization (D&A).
The formula to calculate SDE is as follows.
What is the Difference Between SDE vs. EBITDA?
The SDE and EBITDA are two different methods to measure the profit potential of a particular company.
The adjustments applied to EBITDA and SDE are relatively similar, with the primary benefit being related to comparability (i.e. they facilitate more uniform, “apples-to-apples” comparisons).
However, the one notable difference between SDE and EBITDA is in the adjustment for the owner’s salary.
Unlike EBITDA, the SDE metric includes adjustments to the owner’s salary, including the discretionary spending of company funds on personal expenses like meals and travel.
The range of companies that the SDE metric is measured for is much more limited, too, in comparison to EBITDA, which is used to analyze companies of all sizes.
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Small Business SDE Calculation Example
- Pre-Tax Income (EBT) = $400,000
- Owner’s Compensation = $100,000
- Interest Expense, net = $30,000
- Depreciation and Amortization (D&A) = $40,000
- Discretionary Expenses = $60,000
- Non-Recurring Expenses = $10,000
The calculation of the company’s SDE on an LTM basis is straightforward, as we adjust pre-tax income (EBT) by adding back the owner’s compensation, interest, D&A, discretionary expenses and non-recurring expenses.
In conclusion, the sum comes out to $640k, which reflects the concept of seller’s discretionary earnings (SDE).
- Seller’s Discretionary Earnings (SDE) = $400k + $100k + $30k + $40k + $60k + $10k = $640k