“Cash rules everything around me. C.R.E.A.M. Get the money. Dolla, dolla bill y’all.”
-Wu-Tang Clan
In the world of lower market M&A, SDE is the principal reason a buyer acquires a company rather than build from scratch. It’s arguably easier to buy rather than build. Seller’s Discretionary Earnings (SDE) are the barometer of small businesses. It’s the metric that reveals the true profitability of a business, beyond what traditional financial statements might show. Whether you’re considering buying a small business or preparing to sell one, understanding SDE can mean the difference between a fair price and a great deal. Let’s delve deeper into what SDE actually is and its significance in lower middle market valuations.
At its core, SDE represents the total financial earnings a full-time owner-operator would realize from a business annually. This isn’t just a technical term for accountants to bandy about; it’s essentially the business owner’s annual ‘paycheck’ for operating the business. Seller’s Discretionary Earnings are what gets an owner up in the morning each day.
It’s important to note that SDE can vary significantly across different types of businesses. Tech/Consulting style businesses, for instance, often boast high SDE due to typically higher margins and lower direct costs. Conversely, Brick & Mortar style businesses tend to have lower margins, given the additional expenses such as rent, utilities, and other operating expenses that must be considered.
To calculate SDE, one starts with the net profit from the financial statements and makes adjustments for:
- Owner’s Salary and Benefits: All personal expenses paid through the business.
- One-time or Non-recurring Expenses: Such as unique legal expenses.
- Non-cash Expenses: Including depreciation and amortization.
- Discretionary Expenses: These may range from travel to entertainment expenses not essential to business operations.
For sellers, an accurate portrayal of SDE can significantly enhance the perceived value of their business. It provides a truer representation of a business’s earnings, reflecting what an owner truly gains from the business. If taking out a loan to acquire a business, SDE can give an owner insight into how much profit they will take home after loan payments.
For prospective buyers, SDE is a crucial measure of a business’s underlying profitability and potential for future growth. If taking out a loan to acquire a business, SDE can give a buyer insight into how much profit they will take home after loan payments.