If you’ve been in the marker for a small business, you have probably come across the term “Seller’s Discretionary Earnings” (SDE). SDE is a financial metric used in small business valuations to determine the potential profitability of a business and represents the amount of money a business owner can potentially earn from the business in a year.
SDE is particularly useful for small businesses where the owner may have more control over the business’s finances. In these cases, SDE provides a more accurate representation of the business’s potential earnings than traditional financial metrics such as net income or EBITDA.
Why should you care? Because SDE is critical in determining the value of a small business when buying or selling.
How to Calculate SDE
SDE is calculated by adding the business’s net income, the owner’s salary, and any non-cash expenses such as depreciation and amortization. Any one-time or non-recurring expenses are also added back.
Additionally, special expenses that the owner is charging that could be considered optional should be added as well (for instance, if the business needs to lease for work they chose a Ferrari, a large part of this should be added back in since while a car may be required for the business, a Ferrari most likely is not)
In short, that means:
SDE = Earnings + Interest + Depreciation + Owner's Personal Expenses
Take this quick example:
- Business: Red Rocket Mini Golf
- Earnings/EBITDA = $80,000
- Interest = $2,400
- Depreciation = $3,000
- Least a Ferrari for one year = $36,000
- Cost of a Toyota Camry which they didn’t lease = $5,400
In this example, we calculate SDE using the following formula:
SDE = $80,000 + $2,400 + $3,000 + ($36,000 - $5,400) = $116,000.
As mentioned earlier, although the business may need a car, it probably doesn’t need a Ferrari. The owner probably could have gotten by with a Camry. The Camry has an annual lease of $5,400, instead of the $36,000 for the Ferrari. This allow us to add back $30,600 to the SDE ($36,000 – $5,400)
Note: If you determine that you can use an existing car and don’t need to incur a lease at all you can add the $5,400 back in as well.
Calculating SDE Valuation
To value a small business one typically takes SDE and multiply it by a constant to get a valuation.
Continuing the example from above, say the business SDE is $116,000. It’s a mini golf business which is in the entertainment industry. Per BizBuySell, that means this business has an SDE multiple of 2.49. So this then yields the following for the valuation:
SDE Valuation = SDE x Multiple = $116,000 x 2.49 = $288,840
Calculating Total Valuation
To get more accurate, you can also add in the sellable inventory (the price you could actually fetch were you to sell it – many times this is a fraction of what seller says the inventory is worth.)
Continuing the example, say the inventory on hand is theoretically worth $250,000. However, you know you could only sell it for 1/10 of that ($25,000) were the business to ever fold.
So the adjusted valuation would be:
Total Valuation = $288,840 + $25,000 = $313,840
Calculate SDE and Valuation Automatically
If you don’t want to go to the trouble of calculating the SDE and valuation automatically, we’ve created a free business valuation tool which you can use for this purpose. Just answer some questions and the SDE, valuation, and health ratio will be shown.