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  • Writer's pictureJason Huett

What is "Seller Discretionary Earnings (SDE)?"


If you've been in the market to buy or sell a business, chances are you've come across the term, "SDE" which stands for Seller Discretionary Earnings. In this article, we'll dive into how SDE is calculated and how you can better put this importance metric to work.

The Definition of SDE

"The earnings of a business prior to income taxes, depreciation, amortization, interest, non-operating income and expenses, nonrecurring income and expenses, one owner's entire compensation (including benefits and any non-business or personal expenses paid by the business)." 

SDE can be confusing because business owners take their compensation in different forms. Owners (technically, "members") of LLCs typically take "draws;" owners of S-Corps and C-Corps receive salaried and/or bonus-structure compensation plans.

The Impact of SDE Adjustments

This structure has an impact on the SDE calculation. For the sake of illustration, let's assume an S-Corp corporate structure where the owner takes a salary of $150,000 annually in a business ("ABC Widgets") with $3,000,000 in Revenue. (We won't go into any tax issues in this discussion or highlight strategies used by ownership to reduce taxes.)

If we were to calculate SDE in this scenario, we would add the $150,000 salary to the Net Profit (or Net Operating Income) to calculate SDE. This would give a buyer a more complete picture of the total benefit of the business to the owner.

To make SDE a bit more confusing, all of the calculations are subject to being challenged by the Buyer in a transaction. Often, Buyers will dismiss a Seller's explanation of why a specific SDE adjustment has been added back in. Remember, Seller Discretionary Earnings most often increases the valuation and sale price of the business.

Alternatively, savvy Sellers have analyzed each line item in their Profit and Loss Statement, made their SDE adjustments ("add-ins"), and usually come prepared to defend their adjustments.

To better understand the SDE calculation, we'll continue this example with the following assumptions:

  • The CEO (and owner) of ABC Widgets has an annual salary of $150,000.

  • The company has Annual Gross Revenues of $3,000,000.

  • The company has a Net Operating Income (NOI) of $500,000.

  • The company spends 2%, or $100,000 of Gross Revenue on Marketing.

  • The CEO calculated SDE with the following add-backs - all on an annual basis:

    • $10,000 for Donations

    • $5,000 for his annual license

    • $25,000 for Depreciation on equipment

    • $10,000 for Interest Expense

To take a position regarding these add-backs, we would need to know more about the nature of the business. In this analysis, we'll take a friendly approach. In this case, it's probably reasonable for him to add-back Donations and Depreciation since it could be argued that they weren't absolutely critical in the operations of the business OR they were non-cash expenses.

In other words, if he hadn't spent the money on those items, would the business have been impacted? Probably not. However, the $5,000 expense for his annual license would likely be challenged if it was added back in as it's probably a critical expense for the business.

SDE Math

In summary, here's a visual depiction of the SDE calculation in this scenario:

Seller Discretionary Earnings

Plugging the numbers in...

500,000 + $150,000 + $25,000 + $10,000 = $685,000 Wait - we need to add in the $10,000 for the Donation. Why? Because it was a discretionary expense and wasn't critical for the operations of the business (although it was a kind gesture!).

So, the total SDE in this example would be $695,000. This is an oversimplified example - typically, there are many discretionary add-ins, but, we're not done yet. Let's say the buyer challenges the seller during the course of the negotiation process. Where is this most likely to occur?

Buyers Challenge SDE

Every detail in the process of selling a business is important. Be mindful of SDE add-ins because buyers are generally aware of the impact on valuation. In the example above, likely challenges may not confront the seller on their SDE adjustments, but rather may originate from other areas in the financials that seem light:

  • CEO Salary - may be flagged for being too low. Buyers will typically look at industry averages and Gross Revenue to make a judgement on the CEO's compensation.

  • Marketing Expense - 2% is extremely low. This is perhaps the biggest red flag in this example. Most companies average considerably higher with Marketing running 5-10% of Gross Sales. So, the seller will need to be able to explain why the Marketing Expense is so low (maybe the business has a strong Referral program and Pricing Strategy that drives this expense down).

If you're on the selling side, ask yourself this question: "Are the SDE adjustments I'm using likely to trigger a negative reaction from a buyer?" Remember, negotiation doesn't mean we want to be shrewd all of the time — only at the right times. It's never worth risking a deal for a proportionally small amount of money.

If you have questions regarding your company's SDE calculation, don't hesitate to reach out!

To your success,

Jason Huett

CEO | CMO | Business Broker

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