Understanding SDE is essential whether you’re buying or selling a business, as it provides a clear picture of the business’s profitability from an owner-operator perspective.
What is SDE?
SDE stands for Seller’s Discretionary Earnings, a key metric used to determine the true profitability of a small to mid-sized business. SDE shows how much income the business generates for the owner, making it a crucial figure for potential buyers to evaluate when considering a purchase.
Unlike other financial metrics, SDE adjusts the business’s net income to account for expenses that are not essential to the daily operation of the business or that benefit the current owner personally. This makes SDE an ideal metric for small business valuations because it reflects the cash flow available to a single, full-time owner-operator.
Why is SDE Important?
SDE is important because it provides a more accurate picture of a business’s earning potential than just looking at net income or profit. For buyers, SDE gives insight into how much money they can reasonably expect to make as the new owner. For sellers, it helps demonstrate the true profitability of the business by adjusting for discretionary and non-operational expenses.
Using SDE in a valuation helps both parties understand the earning potential of the business once the new owner takes over. It also serves as a key metric in determining the sale price of the business, especially for smaller businesses that rely heavily on owner involvement.
How is SDE Calculated?
To calculate SDE, start with the business’s net income and then add back any owner-specific expenses or non-essential costs that the current owner chooses to incur. Here’s a step-by-step breakdown of how SDE is typically calculated:
- Start with Net Income:
Begin with the business’s net income from its financial statements. - Add Back Owner’s Salary:
Any compensation paid to the owner should be added back since SDE assumes the buyer will take over this role. - Add Back Owner’s Benefits:
This includes any personal expenses paid for by the business that aren’t directly tied to its operations, such as health insurance, travel, or car payments. - Add Back Non-Recurring Expenses:
Any one-time expenses that are not expected to continue after the sale (e.g., legal fees for a lawsuit or major repairs) should also be added back. - Adjust for Depreciation, Interest, and Taxes:
Add back non-cash expenses like depreciation and interest, as well as taxes that might vary depending on the new owner’s situation.
The resulting figure is the SDE, which represents the total amount of discretionary earnings available to the new owner.
An Example of SDE Calculation
To illustrate, let’s look at an example of how SDE is calculated for a small business:
- Net Income: $100,000
- Owner’s Salary: $50,000
- Owner’s Benefits (e.g., health insurance, travel): $10,000
- One-Time Legal Fees: $5,000
- Depreciation & Interest: $3,000
In this case, the SDE would be:
SDE = $100,000 (Net Income) + $50,000 (Owner’s Salary) + $10,000 (Owner’s Benefits) + $5,000 (Legal Fees) + $3,000 (Depreciation & Interest) = $168,000
The SDE of $168,000 represents the total earnings available to the new owner, reflecting the true profitability of the business.
SDE vs. EBITDA: What’s the Difference?
While SDE is a common metric for valuing small businesses, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is often used for larger companies. The key difference between the two is that SDE focuses on owner-operated businesses and includes the owner’s salary and benefits, while EBITDA removes owner-specific compensation. This makes EBITDA more applicable to businesses with multiple owners or larger companies with more complex management structures.
For small businesses, SDE is usually the preferred method, as it provides a clear picture of the earnings potential for a single, full-time owner-operator.
Why Buyers and Sellers Should Understand SDE
Both buyers and sellers benefit from understanding SDE in the context of business valuation. For buyers, it provides an accurate reflection of how much income they can expect after taking over the business. For sellers, presenting a clear SDE can help attract serious buyers and justify the asking price.
By focusing on SDE, both parties can make informed decisions and feel confident in the valuation process, ensuring a smoother and more transparent transaction.
How SDE Impacts Business Valuation
SDE plays a critical role in determining the sale price of a business. Most small businesses are valued using a multiple of their SDE, meaning the business’s SDE is multiplied by a factor that reflects industry standards, market conditions, and the overall health of the business. Common multiples range from 2x to 4x, depending on the industry and other factors.
For example, if a business has an SDE of $150,000 and the market multiple is 3x, the business would be valued at approximately $450,000.
Seller’s Discretionary Earnings (SDE) is a vital metric for anyone looking to buy or sell a small business. By understanding how SDE is calculated and why it matters, you can gain a clearer picture of a business’s earning potential and make more informed decisions during the valuation process.
If you’re considering buying or selling a business in the Florida, experienced business brokers from Murphy Business Sales Tampa can help you calculate the SDE and guide you through the entire valuation process. Contact us today to learn more about how we can assist with your business valuation needs.