What is Seller’s Discretionary Earnings?

When you work with our team at Murphy Business Atlantic, you will often hear us use the term Seller’s Discretionary Earnings. Seller’s Discretionary Earnings (SDE) is an industry standard method for communicating the earnings of a small business. Typically we use SDE when talking about a business with less than $1 million in earnings – for larger businesses we use EBITDA. You may also hear us use Seller’s Discretionary Earnings interchangeably with the word cash flow. Although this is not completely accurate, SDE is an indication of profitably and can be used as a “proxy” for cash flow.

In its simplest form, Seller’s Discretionary Earnings can be calculated as follows:

Start With: Net income before taxes

Plus: The salary of one full-time owner (not dividends)

Plus: Depreciation and amortization

Plus: Interest expense on long-term debt

Plus: Any one-time expenses that will not occur in the future

Plus: Any personal expenses related to the owners of the business.

Equals: Seller’s Discretionary Earnings.

SDE attempts to standardize the earnings of a business by excluding items that are variable and discretionary from company to company. For example, one business may have a heavy debt load while another business may have none. This is why we add back the interest expense on long-term debt. The same goes for taxes, as each business will use a different tax strategy. This is why we use pre-tax earnings. Depreciation and Amortization are non-cash expenses, so they are also excluded because no money is actually spent. Finally, the owner’s salary and personal expenses will vary greatly from business to business, and those expenses will no longer exist when the owner is removed. So they are added back as well.

So what does all this mean to a business buyer? Seller’s Discretionary Earnings is essentially the amount of earnings that a business generated in a given year, and is the amount of money that a buyer can use to:

1. Pay themselves a salary

2. Service debt

3. Cover any capital expenditures that may be required

4. Generate a return on the initial down payment invested

Imagine you are analyzing the financials of a business that you would like to buy. If the business generates enough cash to pay yourself, pay your debt, cover any upcoming capital expenditures (if applicable), and generate a reasonable return on the cash you invested, would you buy it? Many factors go into the decision to buy a business, but financially, this sounds like a fair deal.