Small privately own companies earning a yearly income of 1 million or less are valued based on SDE (Seller’s Discretionary Earnings). When the question of selling a small business arrives, valuing it with a market recognized method is vitally important. A widely accepted valuation method such as SDE is fair to both seller and buyer, thus companies valued by that method greatly influence potential buyers.
What is SDE: Seller's Discretionary Earnings is measured by EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and adding company owner’s salary, compensations and perks. To summarize: SDE = EBITDA + Owner's Compensation.
Now we are going to understand how to measure SDE.
Video: Tim Quarles discusses the terms Seller’s Discretionary Earnings (SDE) and EBITDA and what they mean if one is thinking of selling his/her business.
Common add-backs when calculating SDE
1. Salary owner taking from the company: First adjustment is to add-back owner’s salary, but it’s often complicated. Whether the owner is a full time contributor, or just an idle supervisor, has some special working skill or stays in the office all day. All the factors have to take into consideration.
2. Condition of the company equipments: Another thing to consider is the condition of the company assets and equipments. Do they have to be replaced soon? If they are brand new, then add-back in minimum.
3. Adding interest expense: Interest expense is not recognized as expenditure and has to be added back.
4. Vehicle rent, repair and gas charge: If the owner and his family members use company vehicles for personal need, the total cost of rent, gas and repair have to be added back.
5. Personal club membership expenses: Personal club membership expenses such as golf or hunting club expenses are included in add-back. Obviously, some club promotional work is needed for the company.
6. Cell phone and utilities: Some owner’s do use business cell phones for personal use and pays his home utilities with business funds. These expenses have to add-back.
7. Relocation or lawsuits: Costly relocation of the business or the lawyer’s fee, all the expenses have to include in the add-back.
The Owner has to add all above expenses to EBITDA for SDE calculation. For an accurate calculation it is best to take an average SDE for a period of 3 to 5 years.
Three elements that influence SDE metric
- Size of the business
- Total number of locations, where the business is established
- Size of the staff working in the business
Difference of opinion over SDE between buyers and sellers
1. The case of several owners: In the case of several owners owning a company, only one owner’s salary is add-back to the total earnings. So, the difference of opinion occurs when fixing the other owner’s salary according to the salary given to a normal employee.
2. Usage of club membership or arranging a party: Another serious area of dispute is using a club membership to promote business or arranging a party for promotional purpose. This is often a grey area. Meeting with wealthy and influential people is vital for a small company owner. With the right connections a small business can be doubled or tripled within a year. The question remains, is it a business or leisure? And who decides that?
3. Recurring expenses: Recurring expenses often cause disputes. Case in point is maintaining and upgrading cost of the company websites. With changing times a thriving company needs eye-catching websites and quality content. All of these expenses are owner’s domain. So, these expenses are going to be added back or not. Another thorny point when calculating Seller's Discretionary Earnings.
Valuation of a small business objectively and accurately is not an easy job. It is best to seek for a professorial help for an accurate SDE calculation. Sites like www.ibba.com are there for a prime source of authentic information.