How Small Businesses Are Valued Based
on Seller's Discretionary Earnings (SDE)

How Small Businesses Are Valued Based on Seller's Discretionary Earnings (SDE)

In the last issue (#5), we discussed The No-Cost Method to Start Business Exit Planning.  In this issue we will help you understand How Small Businesses Are Valued Based on Seller's Discretionary Earnings (SDE).

A Favorite Famous Quote 
"Accounting is the language of business."   Warren Buffett

How Small Businesses Are Valued Based on Seller's Discretionary Earnings (SDE)

Public companies and middle market businesses are valued as a multiple of EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization.  However, smaller businesses are valued as a multiple of Seller's Discretionary Earnings (SDE), which can be defined as EBITDA + Owner's Compensation.  Therefore, SDE is typically the net income (or net loss) on the company tax return + interest expense + depreciation expense + amortization expense + the current owner's salary + owner perks.

Because it is the foundation of business valuation for small businesses, SDE is an important concept to understand.   SDE is typically the net income (or net loss) on the company tax return + interest expense + depreciation expense + amortization expense + the current owner's salary + owner perks.

Seller's Discretionary Earnings normalization

To arrive at SDE, the seller's financial statements are "normalized" (alternate terminology includes: "recast" or "stabilized").  The typical "SDE Normalization" presents the seller's regular income statement and then shows each normalizing adjustment (with an explanation) to arrive at the normalized SDE.

Seller's Discretionary Earnings adjustments resulting from personal and/or discretionary expenditures

In addition to the adjustments of EBITDA + Owner's Salary, other adjustments may be necessary.  For instance, it's no surprise that many small business owners run a lot of personal expenses through the business that have nothing to with operating the business.  If properly documented, those personal and/or discretionary expenditures may be added back to SDE.

Other types of Seller's Discretionary Earnings adjustments

• Many small business owners personally own the real estate the business occupies.  If the business is overpaying or underpaying facility rent, the amount needs to be adjusted up or down to reflect the rent a prospective buyer of the business would expect to pay.
• Occasionally there are non-recurring expenses, such as an extraordinary legal bill due to a lawsuit, that may be added back to cash flow.
• There can also be non-recurring income (i.e. sale of a fixed asset at a large gain).
• Some businesses employ multiple family members who may receive above-market compensation.  The above-market portion of their salaries can be added back to the extent there is sufficient expense remaining to enable a prospective buyer to replace those family members at a competitive market rate (or adjust their salaries if they stay on board).
• These are some of the common adjustments, but there may be justification for others.

Small business valuations are based on multiples of Seller's Discretionary Earnings

When it comes to valuing a small business (under $3,000,000 in value), SDE is the common denominator to which a multiple is then applied.

The multiples are driven by a range of financial factors including: 1) financing formulas; 2) the buyer's need to have a reasonable return on investment after paying debt service on the acquisition; and 3) the buyer's need to receive reasonable compensation for the time and effort required to run the newly acquired business.  There are numerous other factors, including the industry, that can also affect the selection of an appropriate multiple.

But one of the primary factors is the level of SDE itself.  For financial reasons, buyers are willing to pay a higher multiple for higher SDE.  The following is representative of the range of multiples at various "cash flow" (SDE) levels:

CAUTION:  The above multiples do not apply to all industries.  For instance, the construction industry would typically have lower multiples than displayed above.

Seller's Discretionary Earnings is a very important concept to understand

Because it is the foundation of business valuation for small businesses, Seller's Discretionary Earnings (SDE) is an important concept to understand.  Having an SDE below $100,000 is a major obstacle to a successful sale of a business (but not impossible).  (Read Issue #57 - Inadequate Seller's Discretionary Earnings.) Other obstacles that contribute to inadequate SDE and have future newsletter articles devoted to the topic include: Issue #58 - Low or Inconsistent Gross Margins, Issue #59 - Inadequate Sales and Marketing and Issue #72 - Excessive Personal Expenses and Skimming Cash. 

Another Favorite Famous Quote 
"When business leaders ask me what they can do for Indiana, I always reply: 'Make money.
Go make money. That's the first act of corporate citizenship. If you do that, you'll have
to hire someone else, and you'll have enough profit to help one of those
non-profits we're so proud of."  Mitch Daniels

Overcome the Power of Inertia

Overcome the Power of Inertia and call a business broker for a free consultation. Many brokers offer no-charge, no-obligation evaluations of small businesses. They can provide a broker opinion of value and help you identify obstacles to a successful sale as well as opportunities for improvement to increase the value of your business. That is a great way to start planning for a successful and profitable exit from your business.