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The business math

Seller's discretionary earnings

SDE / discretionary earnings / seller's discretionary cash flow

In short

Seller's discretionary earnings (SDE) are a small business's earnings counted before income taxes, interest, depreciation, one-time items, one owner's entire pay and benefits, and personal expenses the business paid. When a selling price is set as a multiple of SDE, every dollar accepted as an add-back lifts that price by the multiple.

The International Business Brokers Association keeps a glossary meant to standardize the vocabulary of the business brokerage profession. It files seller's discretionary earnings under discretionary earnings, and lists seller's discretionary cash flow and adjusted net as other names for the same measure.

The definition counts a business's earnings before income taxes, non-operating and nonrecurring income and expenses, depreciation and amortization, and interest. It also counts them before one owner's entire compensation, including benefits, and before any personal or non-business expenses the business paid. The IBBA describes add-backs as expenses added back to net income. The aim is figures as close as possible to the economic earnings the business produced.

Adjusted EBITDA, in the same glossary, starts from a similar list but treats the owner differently. It removes the owner's pay and then replaces it with market rate compensation and benefits for someone doing the owner's job. Its entry also does not list personal expenses paid by the business among the items it counts before. SDE therefore shows earnings for one owner who works in the business, and adjusted EBITDA shows the business with a paid manager in that seat.

Only one owner's pay comes out under the discretionary earnings definition, so the pay of any other owner stays in the earnings as a cost. In its entry for owner total compensation, the same glossary counts an owner's pay after the compensation of all other owners has been adjusted to market value.

The IBBA says a multiple can be the ratio of selling price to discretionary earnings for a small business. The IRS business valuation guidelines, written for IRS staff engaged in valuation practice, say historical financial statements should be adjusted where necessary. They also say multiples should be consistent with the benefit stream selected. Applying that same consistency principle, a multiple drawn from sales priced on SDE does not fit adjusted EBITDA. For earnings that swing, the IBBA lists a weighted average method that accounts for sales and profits varying from year to year.

In practice

A plumbing company shows $120,000 of profit before income taxes. The owner takes $90,000 in salary and benefits, and the books carry $15,000 of depreciation, $5,000 of loan interest and a one-time $10,000 legal bill. Adding those back gives SDE of $240,000. Swapping the owner's pay for a $70,000 manager gives adjusted EBITDA of $170,000. A multiple of 3 drawn from sales priced on SDE puts the price at $720,000. Applying that same multiple to the $170,000 adjusted EBITDA by mistake gives $510,000, understating the price by $210,000. The figures are a worked example.

Why it matters to you

For a buyer, SDE is counted before owner pay, interest, income taxes and depreciation. The new owner's salary, loan interest, the tax bill and the cost of replacing worn equipment all come out of it. For a seller, a multiple drawn from sales priced on one measure and applied to the other misprices the business.

What to ask or check

  1. 01Is the earnings figure in your listing or offer SDE or adjusted EBITDA, and was the multiple drawn from sales priced on the same measure?
  2. 02Which expenses did the business add back, and what records show each one was personal, one-time or non-operating?
  3. 03If more than one owner works in the business, is only one owner's pay added back, and was each other owner's pay adjusted to market value?
  4. 04How many years of the business's earnings sit behind the figure, and are they averaged or weighted?

What people get wrong

That SDE and adjusted EBITDA are the same number. The IBBA glossary adds back one owner's entire pay and personal expenses the business paid for SDE. Its adjusted EBITDA entry replaces that pay with market rate compensation and does not list personal expenses, so SDE comes out at least as high.

Red flags

  • A price quoted as a multiple of earnings without saying whether those earnings are SDE or adjusted EBITDA.

Keep reading

Margin

Margin is the difference between selling price and cost, stated either as a percentage of the selling price or per unit. The standards board that defines it also records that managers differ widely in the assumptions they use. So the number only means something once you know which costs are inside it.

Return on investment

Return on investment is profit measured against capital invested. The standards board that defines it says related measures differ mainly in how investment is defined, which is where most disagreements live. The tax code draws the sharper line: money you deduct this year is spent, money you capitalize is invested.

Break-even point

The break-even point is where total cost and total revenue are equal, so there is no loss or gain. The SBA states it plainly and then states the limit plainly too: it is an estimate for lender viability and a business plan, not an accounting result, and the formula assumes a single product or service.

Depreciation recapture

Depreciation recapture is the tax rule that treats gain on selling depreciated business equipment and other section 1245 property as ordinary income, up to the depreciation allowed or allowable. It decides how much of the money from selling equipment written off with Section 179 or bonus depreciation is taxed as ordinary income.

Cost per acquisition

Cost per acquisition is what you paid for each counted conversion, spend divided by conversions. Google expands the abbreviation as cost per action, not acquisition. It inherits whatever your conversion column counts, so two businesses can report the same figure and mean entirely different things.

Customer lifetime value

Customer lifetime value is the dollar value of a customer relationship, based on the present value of projected future cash flows. The LTV column in your analytics is a different quantity: measured revenue from users the tool could identify, sampled above a limit, and often zero even at the 90th percentile.

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