Sellers Discretionary Earnings >>> What is it and how do I calculate?

Author: Rob Marriott

Sellers Discretionary Earnings >>> What is it and how do I calculate?

You have likely heard about Sellers Discretionary Earnings (SDE) but what is it? In practical terms think of SDE as the following:

  • What does a business owner take home or how much ‘benefit’ and income do they make on an annual basis?
  • What does a buyer see as the financial benefit they can make from a business in a year timeframe?

SDE is one financial data point of trying to understand the value of a business. Let’s give a quick example; let’s say an entrepreneur is asking $1,000,000 for their business and the SDE is $250,000. In this case the entrepreneur is asking the buyer to pay today 4x what a buyer could take home if the business performs over the next 4 years what it has performed the past year.

How do we calculate Sellers Discretionary Earnings, let’s look at? We have included more steps then most definitions you will find but if you are a first-time business seller this formula should be simple and mechanical to follow- be patient and allow a bit if time.

Step 1 Basic Income Statement Adjustments
  1. Business Pre-tax earning
  2. + ADD BACK Depreciation/ Amortization
  3. + ADD BACK Interest Expense
  4. RESULT: EBITDA (Earnings before interest, tax, depreciation, amortization)

** Note: Start at EBITDA on your financial statements and skip 1, 2, 3

Step 2 Normalizations
  1. Start with EBITDA from step 1
  2. + ADD BACK: Owners annual total compensation
  3. +/- ADD BACK OR DEDUCT: One-time gains or expenses
  4. +/- ADD BACK OR DEDUCT: Avoidable business expenses or income not part of business selling
  5. RESULT: Sellers Discretionary Earnings one business owner
Step 3 Does the business have more than one business owner being paid?

If Yes then complete step 3 otherwise Sellers Discretionary Earnings is result in step 2

  1. Start with Sellers Discretionary Earnings one business owner from step 2
  2. +/- ADD BACK OR DEDUCT: Adjust compensation of all other business owners to market value
  3. RESULT: Sellers Discretionary Income multiple owners

Illustrative Example

Ok example time. Let’s assume John is selling his world-famous chicken and rib restaurant. Last year John had the following results:

  • Pretax earnings of $1,000,000
  • Depreciation of equipment of $100,000
  • John took his management team for a $15,000 offsite strategic planning session away from the office
  • John built a website that cost $50,000 to build and it is a one-time expense
  • John took home $125,000 personally last year
  • John’s company paid $75,000 in interest last year
  • John has one business partner who will retire when the business is sold and earned $125,000 last year. A new employee would cost $100,000 to replace the business partner who is retiring. The net result is a $25,000 savings.

See the calculation below on what John’s Sellers Discretionary Earnings would be.

Step 1 Basic Income Statement Adjustments

Step 2 Normalizations

Step 3 Multiple Owners?

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