Seller's Discretionary Earnings

The seller's discretionary earnings measure the business's cash flow that reflects the total income generated by the company, including the owner's salary, benefits, and any other discretionary expenses that may not be essential to the company's operation. It is often used in the valuation of small businesses that are being sold.

It helps potential buyers understand the cash flow the business generates and provides a more accurate picture of its profitability. By understanding it, buyers can estimate the amount of money they could earn from the company if they acquire it.

• The seller's discretionary earnings measure the business's cash flow that reflects the total income generated by the company, including the owner's salary, benefits, and any other discretionary expenses.
• It provides an accurate picture of the business's actual cash flow and profitability, as it considers the owner's involvement and any unique circumstances related to the company.
• It is beneficial in the valuation of small businesses, as these businesses often have a significant amount of owner involvement and may have expenses that are unique to the owner.

Seller's discretionary earnings (SDE) is a financial metric that measures the cash flow generated by a small business and reflects the income available to the business owner. It takes the business's net income and adds back owner compensation, non-recurring expenses, and other discretionary expenses. The resulting figure provides a more accurate picture of the business's actual cash flow and profitability, accounting for the owner's involvement and any unique circumstances related to the company.

The origin of it tracks back to the valuation of small businesses, which often have unique financial characteristics that make them difficult to value using traditional financial metrics, such as earnings before interest, taxes, depreciation, and amortization. It addresses this challenge and accurately represents a small business's financial performance and profitability.

Its significance is its ability to provide a more complete and accurate picture of a small business's cash flow and profitability, essential for making informed business decisions and valuations.

As a result, it is beneficial in selling small businesses, as it helps potential buyers understand the business's actual cash flow and determine a fair price to offer for the company. Additionally, business owners can use the seller's discretionary earnings formula to track their financial performance and identify areas for improvement.

The seller's discretionary earnings calculation involves adding back certain expenses to the business's net income and subtracting costs that are not discretionary. Here is a breakdown of the calculation process:

Step 1: Calculate Net Income

The first step in calculating it is determining the business's net income. Net income is ascertained by subtracting all expenses from the business's total revenue. This includes the cost of goods sold, operating expenses, and any other expenses incurred by the company.

Net Income = Total Revenue - Cost of Goods Sold - Operating Expenses - Other Expenses

Step 2: Add Back the Owner's Salary

The owner's salary is added to the net income as it is considered a discretionary expense. This represents the compensation paid to the business owner, including any benefits such as health insurance or retirement contributions.

Net Income + Owner's Salary

Step 3: Add Back Non-Cash Expenses

Depreciation and amortization expenses are non-cash expenses added to the net income.

Net Income + Owner's Salary + Depreciation + Amortization

Step 4: Add Back Interest and Taxes

Interest and taxes are added back to the net income as discretionary expenses. Interest represents the cost of borrowing money, while taxes represent the income tax expense incurred by the business.

Net Income + Owner's Salary + Depreciation + Amortization + Interest + Taxes

Step 5: Add Back Other Non-Recurring Expenses

Other non-recurring expenses, such as legal fees or restructuring costs, are added back to the net income as they are considered one-time or non-recurring expenses.

Net Income + Owner's Salary + Depreciation + Amortization + Interest + Taxes + Other Non-Recurring Expenses

Step 6: Subtract Non-Discretionary Expenses

Non-discretionary expenses, such as rent or utilities, are subtracted from the total to arrive at the final SDE figure.

SDE = Net Income + Owner's Salary + Depreciation + Amortization + Interest + Taxes + Other Non-Recurring Expenses - Non-Discretionary Expenses

Let us understand it in the following ways.

Example #1

Suppose a small landscaping business has a net income of $80,000 annually. The business owner also pays themselves a salary of $50,000 per year and incurs $10,000 in depreciation and $5,000 in amortization expenses. The company also has $2,500 in interest expenses and $7,500 in income tax expenses.

In addition, the firm incurred $15,000 in other non-recurring costs, such as legal fees related to a lawsuit. Finally, the company has $20,000 in non-discretionary expenditures, such as rent and utilities.

To calculate the SDE for this business, we would start with the net income of $80,000 and add back the owner's salary of $50,000, depreciation of $10,000, amortization of $5,000, the interest of $2,500, taxes of $7,500, and other non-recurring expenses of $15,000.

Net Income = $80,000

Owner's Salary = $50,000

Depreciation = $10,000

Amortization = $5,000

Interest = $2,500

Taxes = $7,500

Other Non-Recurring Expenses = $15,000

SDE = $80,000 + $50,000 + $10,000 + $5,000 + $2,500 + $7,500 + $15,000 - $20,000

SDE = $150,000

In this example, the SDE for the landscaping business is $150,000. This figure represents the total income available to the business owner, including their salary and any other discretionary expenses incurred by the company.

Example #2

In January 2022, The New York Times reported the sale of a popular sports website called The Athletic which a private equity firm had acquired for $550 million.

According to the same report, the valuation of The Athletic was based on a multiple of its SDE, estimated to be around $50 million. The multiple used in the valuation was not disclosed, but it is common for digital media companies to be valued at between three and five times their SDE.

Seller's discretionary earnings and earnings before interest, taxes, depreciation, and amortization evaluate a business's profitability. However, there are some critical differences between the two measures:

1. Definition: SDE is a measure of a business's cash flow that reflects the total income generated by the company, including the owner's salary, benefits, and any other discretionary expenses. EBITDA, on the other hand, is a measure of a business's profitability that excludes non-operating costs.
2. Owner's Compensation: SDE considers the owner's compensation a business expense, whereas EBITDA does not. This means that SDE reflects the income available to the business owner, while EBITDA does not consider the owner's compensation.
3. Non-Operating Expenses: EBITDA excludes non-operating expenses like interest, taxes, depreciation, and amortization, while the seller's Discretionary Earnings do not. This means that EBITDA provides a more accurate picture of the business's operating profitability, while SDE includes all expenses, both running and non-operating.
4. Usefulness: EBITDA is popular among investors and analysts to evaluate the operating performance of a business, particularly in the context of mergers and acquisitions. On the other hand, SDE is more common as it provides a fair picture of the company's actual cash flow and profitability.

This has been a guide to what is Seller's Discretionary Earnings (SDE). Here, we explain its comparison with EBITDA, how to calculate it, and its examples. You can learn more about from the following articles –

• Discretionary Income
• Earnings Management
• Earnings Season