Small businesses are different and if you are looking to buy one or sell yours, finding a fair price is difficult. We can’t use the same metrics that are made for valuing big enterprises. So, the best metric for finding the value of a small business is SDE: Seller’s Discretionary Earnings. It provides a clear picture of a company’s true earning potential.
What is Seller’s Discretionary Earnings?
There are many valuation methods for a small business. You can simply use Revenue or Profit or EBIDTA. But an SDE is better here.
Seller’s Discretionary Earnings, or SDE, is a measure of how much profit your business provides to a full-time owner-operator. It is an important financial metric used to determine the true historical benefit to the owner of a small business.
It tells the buyer how much cash flow they will get from the business. So, it means adding back the salary that the owner is taking away and the expenses that are not used in regular operations. We will discuss the exact formula later. You can say it tells the buyers how much they will have in hand to manage the business when they purchase it.
And if you are a finance person, SDE can give you a quick approximation of a business’s free cash flow. It allows for an apples-to-apples comparison between businesses, whether they’re in the same industry or not.
Note that SDE is not equal to Valuation. Valuation also involves multiplying this number by a multiple. The multiple can vary industry by industry. It can go as low as 1.5 times or as high as 4 times in some cases.
Small Business Valuation = SDE x Multiple
Usually, we use SDE based on the data of the last 12 months, but you also use the weighted average of the last 2-3 years.
However, there are some downsides to it as well. It is just a ‘rule of thumb’ method if you are looking to acquire a business because it doesn’t account for income taxes and net working capital. The concept of adding back a few expenses also might create confusion during buyer-seller meetings.
Is SDE the same as Cash Flow? No. While the term “cash flow” is used loosely in the industry, it’s important to ask for a definition whenever someone speaks of it. True cash flow is determined by a “cash flow statement”.
Difference Between SDE vs EBITDA
SDE is typically used for small businesses with less than $1 million in earnings, while EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) or Revenue is used for larger businesses.
The main difference is that SDE includes owner’s compensation as an adjustment, while EBITDA does not. This makes it more suitable for owner-operated small businesses where the owner’s role and compensation are significant factors in the business’s financial picture.
When the business is small, the new owner might be taking over the responsibility of running the business themselves. But when the business grows to over a million, the new owner might give these day-to-day tasks to a manager. In such cases, EBITDA is better as it doesn’t include the owner’s salary.
Why SDE is the perfect valuation method for small businesses?
SDE is the go-to metric for valuing small businesses because it blends business profits and owner’s compensation into one number. So, it addresses the common issue of separating personal and business expenses in smaller ventures. You’ll find SDE particularly useful if you’re an individual buyer, as it accurately reflects what you’ll pocket after the purchase.
What makes SDE stand out is that it is simple to calculate and eliminates variables that might not affect you post-acquisition, like interest or taxes.
We use SDE in our Shopify Store Valuation Tool also, which is FREE to use.
How to Calculate SDE?
Here’s a detailed explanation and example to illustrate the process to find out the SDE of a business:
- Start with Pre-Tax Income: This is the net income of the business before taxes are deducted. It serves as the baseline for the SDE calculation.
- Add Back Owner’s Salary and Benefits: Since small business owners often pay themselves through the business, their salary and benefits are added back to reflect the true earnings potential.
- Include Non-Operating Expenses: These are expenses not related to the core operations of the business, such as interest payments, business travel,
- Add Non-Cash Expenses: Depreciation and amortization are typical non-cash expenses that are added back because they do not involve actual cash outflow.
- Add Non-Recurring Expenses: These are one-time expenses that are not expected to occur regularly, such as legal fees for a lawsuit or costs related to a major equipment purchase.
Let’s use the provided example of a Restaurant ABC. The owner’s name is Joe. The company’s profit before tax is $120,000. But he already took his salary of $80,000 before. Also, he had spent $10,000 on a business trip. About $20,000 is also recorded for Depreciation and Amortization. And last, he bought some new furniture at the cost of $15,0000 last month.
- Pre-Tax Income: $120,000 (Net Profit + Tax)
- Owner’s Salary: $80,000
- Non-Operating Expenses: $10,000
- Non-Cash Expenses: $20,000 (Depreciation and Amortization)
- Non-Recurring Expenses: $15,000
Now, you just have to add all that up! the Seller’s Discretionary Earnings for Company A is $245,000.
Tips to Optimize Your Business’s SDE
Here are some effective strategies to boost SDE:
- Increase Prices: If possible, try to increase to increase the prices of your products as it will directly reflect in your pre-tax income.
- Streamline operations: Cut unnecessary expenses and improve efficiency. This directly impacts your bottom line and SDE.
- Identify legitimate add-backs: Business owners usually add personal expenses as business expenses when accounting. Look for such personal costs that run through the business. For example, it can be the food you ordered with your business credit card.f
- Document everything: Keep clear records of all expenses and potential add-backs. Solid proof is crucial for a successful exit strategy.
Remember, while optimizing SDE is important, be cautious not to overinflate add-backs. This can create distrust with potential buyers.
To keep things simple, you can try this FREE Business Valuation Tool to find out what your venture is worth.
Conclusion
Seller’s Discretionary Earnings have a significant impact on business valuations, especially for small enterprises and online stores. But remember, while SDE is a powerful metric, it’s essential to use it responsibly and avoid overinflating add-backs to maintain trust with potential buyers.