Calculating your business’ value is key to not only a successful sale but also a best practice for understanding ways to increase the value and plan for an exit or retirement.

Selling a business is a process that comes with lots and lots of paperwork — but there are some documents that are typically key to making sure your business is sold for the right price.

One of these documents is the seller’s discretionary earnings worksheet, which helps put your company’s performance in perspective of other companies and your industry. If you’re a business owner, it’s important to understand what your seller’s discretionary earnings are and how it’s calculated in order to best understand your company’s earnings, and accurately place the right price tag on it when it’s time to sell.

Definition of seller's discretionary earnings

Think of a seller’s discretionary earnings as a rule of thumb — it’s an approximate measure of adjusted cash flow in your business that would be potentially available to a prospective buyer. The seller’s discretionary earnings take your company’s net profit, before taking into account things like taxes, interest, depreciation, and amortization. It also includes things like the owner’s salary, benefits, and personal expenses.

The seller’s discretionary earnings are used to find the SDE multiple, which is a business sales price divided by the SDE. You can use a similar company’s SDE multiple to approximate your business value.

For example, let’s say you own a pizza shop. The pizza shop a few blocks away just sold for $750,000 and had an SDE of $200,000. Their SDE multiple is 3.75. If your pizza shop has an SDE of $250,000, you could approximately value your business at $937,500.

What is a seller's discretionary earnings?

A seller’s discretionary earnings, also known as SDE, is a number used to determine the value of your small business. It’s also one of the most common ways to evaluate a small business’ cash flow when selling and makes it easier for buyers to compare two companies. It helps the buyer understand their potential total financial benefit when they purchase your business.

Why would a buyer need to compare two businesses? Here’s an example: When shopping for a car, one can easily compare prices across different dealerships for the same car using the make and model. But no two businesses are the same, and each one will come with its own special set of expenses, which means there may be different owner perks for sellers across different companies. That’s what makes straightforward metrics like the seller’s discretionary earnings helpful for buyers, allowing them to make an apples-to-apples comparison.

How do you calculate the seller's discretionary earnings?

To calculate the seller’s discretionary earnings for your business, first, take your net profit. This means your company’s earnings before things like taxes, depreciation, and amortization.

Then, you’re going to take into account additional essential and discretionary expenses that are necessary to run the business, to find your SDE. These items are often called add-backs because they’re combined with net income to find the most accurate financial picture for your business.

Types of add backs

When calculating SDE, you’ll always want to add back the owner's salary and payroll taxes, depreciation, amortization, and interest on your business.

Other types of add-backs include personal expenses, business expenses, owner compensation, accounting adjustments, and large, non-recurring expenses. It can include things like car expenses, inventory adjustments, loans, and non-operating income.

What’s not considered an add-back? Things like employee medical insurance, delivery vehicle maintenance, marketing expenses, club memberships, and employee discounts.

Non-recurring

Non-recurring add-backs are expenses that don’t occur in your business’s day-to-day operations and are unlikely to occur again in the future. It’s important to include them to help value your business, but you should make it clear it’s a one-time expense.

Examples of non-recurring expenses include lawsuit settlements and other legal expenses, software and hardware upgrades, relocations, technology upgrades, application fees, settlements, and severance.

Discretionary

Running a small business can be your livelihood, so it’s common for small business owners to pay for personal expenses with business funds. Because of this, it’s important to include discretionary expenses in the SDE. These are expenses that aren’t critical to the performance of your company and are unlikely to transfer over to a new owner.

Discretionary expenses typically include personal travel, car repairs, phone plans, and charitable contributions. These are measured against a seller’s discretionary cash flow when calculating SDE.

Why is SDE important?

The seller’s discretionary earnings are often used to accurately value a business, showing prospective buyers your business’ ability to generate income. The higher your SDE, the more valuable your company will typically be. A lot of small business owners will run personal expenses through the business so comparing SDE is the best way to compare apples to apples.

Many buyers will want to see that your business has a steady history of growth, profit, and (ideally) positive cash flow. The seller’s discretionary earnings can help portray solid business performance.

As a small business owner, you deserve a fair price for your business, but you want to make sure you’re pricing your business accurately and strategically to find the right buyer. Business valuations can often be an obscure process for owners, which makes using something straightforward like a seller’s discretionary earnings multiple more straightforward.

Baton can also help you make sense of your performance and provide a valuation that helps you determine the right time to sell. We provide business owners with a free, data-backed business valuation estimate, along with personalized feedback to help enhance your small business’ value before you sell. You can track your business’ value over time and build a business sale plan of action using our tools. Furthermore, Baton uses proprietary techniques and software to make sense of messy books to get a true picture of SDE making it easy to get started without having to spend thousands of dollars working with a CPA.

What is Included in the seller's discretionary earnings?

Seller’s discretionary earnings first include your company’s pre-tax, net income (aka the profit number that appears on your profit and loss statements), plus things like:

• Any compensation paid to business owners

• Interest expenses

• Income taxes

• Depreciation and amortization

• Discretionary expenses

• Personal expenses

• Accounting expenses

• Non-recurring expenses

• Larger, unexpected expenses

What's the difference between EBITDA and SDE?

While it may be the most common, SDE isn’t the only way to value your business. EBITDA, short for earnings before interest, taxes, depreciation, and amortization, shows your company's ability to make a consistent profit. It’s commonly used by larger companies to measure financial performance and notably does not include owner compensation.

SDE is often used to value small businesses or businesses where the owner is actively involved in the day-to-day operations. Small business owners will often compensate themselves differently, which is why owner salary is included in SDE, while it’s not included in EBITDA. Small business buyers typically will plan to become involved in the daily operations themselves once they acquire the business, so it’s important to know the full value they’re getting, including any compensation.

As a business owner looking to sell, it’s more advantageous to use SDE over EBITDA because it can boost the value of your business.

Other names for SDE

You may see seller’s discretionary earnings appear under other names, such as owner’s benefit, total owner’s benefit, or seller’s discretionary income. All these names basically answer the same buyer question: If I was to acquire your business and become the full-time owner/operator, what’s in it for me?

A seller's discretionary earnings (SDE) worksheet

Determining your SDE is all part of preparing your company to sell — which includes getting all your financial documents together, ensuring your accounting books are accurate and up to date, and, of course, valuing your business. Not only will this help ensure the selling process goes more smoothly, it better prepares you, as the business owner, to make a cleaner break from your business. Baton can help streamline and simplify this process, assisting you with company valuations and connecting you with the right broker.

Conclusion

Wherever you are in your journey, Baton wants to support you. Even if you aren’t considering selling at all and simply want access to partners to help you think about how to organize your business around some of these ideas – you’re in the right place. Get started with Baton today.