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Understanding Seller's Discretionary Earnings When Buying a Small Business

by Dave Driscoll

Seller’s discretionary earnings (SDE), also known as seller’s discretionary income, may be a new term for those who are considering buying a business. Understanding what the term means and how it’s calculated is important when analyzing what the business makes compared to what the business is worth.
Think of SDE as the total amount of cash the business generates through operations that is available to the owner to spend at their discretion. The “discretionary” part of SDE is just that— the owner chooses how to allocate that cash. The follow up question is does the company need that expense to operate?

The expenses that an owner chooses to have the business pay that are unnecessary for the company to operate are called “add backs” because they are added back to net income.

Why would an owner choose to have their company pay an expense that is unnecessary for running the business?

Because many, if not most, owners attempt to show as little income as possible to reduce the taxes they must pay on their annual business earnings.

Conversely, when it’s time to sell the business, the owner has the opposite objective. They want to show as much earnings as possible to justify the highest asking price. Therefore, these non-essential expenses paid by the business are documented as add backs to show the prospective buyer a more accurate picture of the cash that could be at their disposal.

A well-prepared adjusted profit-and-loss statement (P&L) representing five years of data anticipates buyer questions and clearly defines the expenses on the operating statement, including those which are unnecessary for efficient management of the business. Not every seller or business broker knows how to provide that information in a way that’s easy to understand. And not everyone is willing to engage in full and complete disclosure.

A prospective buyer should carefully review and assess each item on the income-and-expense statement when considering buying a business, asking for clarification regarding any questions or concerns.

Important financial questions a buyer may ask include:
- Is each itemized expense necessary to operate the business properly?
- Is the listed total for each item the actual expense, or is the real cost lower or higher than what has been entered in the books?
- What percentage of total expenses does each item account for, and how does that compare to the percentages in prior years? If there is a substantial change in any single category, what is the reason?

A smart business buyer does not simply accept the figures listed in the P&L, tax returns, or other financials of a company being considered without question, but instead does some investigation to learn what the figures truly represent.

Typical add backs to net income that are recognized without question by SBA lenders include:
- owner’s annual salary
- payroll taxes for the owner-manager
- owner’s pension
- owner’s health insurance premium
- amortization
- depreciation
- interest expense (typically for loans that will be paid off when the business is acquired)
- one-time business expenses (an expense that the new owner will not have in the future)
- salary expense for family members who don’t work daily in the business

The above items are discretionary because either the owner decides the amount to be paid or the expense is solely for the owner’s benefit.

In addition, there are many other potential adjustments, such as:
- owner’s personal auto expenses (lease, insurance, gas, repairs, etc.)
- charitable donations, reductions or additions to fair market value for rent paid to owner(s)
- owner’s personal life, health and disability insurance
- non-business meals and entertainment
- non-business travel
- non-business telephone and internet

Proper calculation of SDE is vital to both sellers and buyers. For example, a business showing a “profit” of $140,000 could easily have an actual SDE of $400,000; that’s a huge difference in business value. An experienced business broker is the best resource for a thorough analysis and explanation of add backs and SDE.

Dave Driscoll is president of Metro Business Advisors, a business brokerage, valuation and exit planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at DDriscoll@MetroBusinessAdvisors.com or 314-303-5600. For more information, visit www.MetroBusinessAdvisors.com.

Submitted 12 days ago
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