What is Seller's Discretionary Earnings, and How Does it Affect Valuation?

This blog post will discuss Seller's Discretionary Earnings and how it can help us evaluate companies.

Let's dive right into it.   

Seller's Discretionary Earnings

A small business, usually private, would like to reduce the tax payment. That is why sometimes expenses are recorded in the company belonging to the owner and not the business. The result is that the profit of the business will not correctly express the actual state of the firm. When a buyer arrives and examines the financial statements of the company, the examination of the profit of the business may reveal an incorrect financial situation. In cases like that, Seller's Discretionary Earnings become relevant.

Seller's Discretionary Earnings (SDE) represents the total financial benefit an owner can expect from their business. It is defined as Adjusted EBITDA + Owner Compensation (one full-time owner). Alternatively:

SDE = Net Income (or net loss) + Add Backs

What Are Add Backs?

An add-back is expenses that do not belong to the company's core business. In other words, these are expenses that the firm will not spend if the current owner of the business changes.

If, for example, the current business owner pays a salary of $10,000 to a family member, when a parallel employee's salary is $6,000, then spending $4,000 is unnecessary.

Types of Add Backs

In general, add backs fall into one of five types:

• Standard
• Discretionary
• Non-recurring
• Non-operating
• Accounting adjustments

These items will vary from firm to firm, but understanding these significant types helps identify potential increases or reductions from your business' SDE.

Standard

Here are the most commonly accepted add-backs: 

• Salary for one full-time owner
• Owner's payroll taxes
• Depreciation
• Amortization
• Interest

Discretionary

Discretionary add-backs are costs that don't necessarily donate to your company's operational performance or are unlikely to continue under a new owner.

Examples include:

• Personal travel
• Personal or family member fuel
• Club dues
• Owner's health insurance
• Personal or family member mobile phone
• Charitable contributions

Non-recurring

One-time or non-recurring add-backs are payments unlikely to occur again in the future. You may also hear these referred to as "non-recurring expenses".

Examples include:

• Legal, consulting, or other professional fees
• Transaction-related costs
• One-time technology upgrades
• Facility relocation expenses
• Equipment repair/replacement/upgrade
• Bad debt expense

Accounting Adjustments

Additional accounting adjustments may be necessary to reflect your true earnings. These adjustments may add to, or deduct from, your profit.

Examples include:

• Non-operating income (i.e.: the sale of a vehicle or piece of equipment)
• Inventory adjustments
• PPP loans
• Below-market rent

How Does Seller's Discretionary Earnings is Used in Valuation?

When evaluating companies using methods such as cash flow discounting, it is necessary to base the valuation on profits.

It is customary to divide the firms into two groups - large companies and small ones.

As a rule of thumb, the valuation of a large company with a turnover of 1 million dollars will be carried out based on the earnings before interest, taxes, depreciation, and amortization (more commonly known as EBITDA).

The valuation of smaller companies with a turnover of less than $1 million in revenue will be based on the Seller's Discretionary Earnings.

Conclusion

In this article, we discussed Seller's Discretionary Earnings and How Does it Affect Valuation? Equitest's business valuation team explains. Suppose you look for a straightforward way to evaluate your business, manage your cap table, or create a pitch deck. In that case, you can try our intuitive ai based business valuation software or our business valuation calculator, or you can contact us for free advice or schedule a demo.