Net income may vary significantly from SDE
By Dave Driscoll
Seller’s discretionary earnings (SDE) – also known as seller’s discretionary income – may be a new term for those considering buying a business. Understanding what the term means and how it’s calculated is important when analyzing what the business makes compared to what the business is worth.
Think of SDE as the total amount of cash the business generates through operations that is available to the owner to spend at their discretion. The “discretionary” part of SDE is just that – the owner chooses how to allocate that cash. The follow up question is, does the business need that expense to operate the business?
The expenses the owner chooses to have the business pay that are NOT needed for the company to operate are called add backs because they are added back to net income.
Why would an owner choose to have their company pay an expense that is not necessary to run the business?
Because many, if not most, owners attempt to show as little income as possible to reduce the taxes they must pay on the annual business earnings. Conversely, when it’s time to sell the business,, the owner has the opposite objective…then they want to show as much earnings as possible to justify the highest asking price. Therefore, these non-essential expenses paid by the business are documented as add backs to show the prospective buyer a more accurate picture of the cash that could be at their disposal.
A well-prepared adjusted profit and loss statement representing five years of data anticipates buyer questions and clearly defines the expenses on the operating statement, including which are not necessary for efficient management of the business. But not every seller or business broker knows how to provide that information in a way that’s easy to understand. And not everyone is willing to engage in full and complete disclosure.
Any prospective buyer should carefully review and assess each item on the income and expense statement when considering buying a business, asking for clarification of any questions or concerns.
Important financial questions a buyer may ask include:
- Is each itemized expense necessary to operate the business properly?
- Is the listed total for each item the actual expense, or is the real cost lower or higher than what has been entered in the books?
- What percentage of the total expenses does each item account for, and how does that compare to the percentages in prior years? If there is a substantial change in any single category, what is the reason?
A smart business buyer does not simply accept the figures listed in the P&L, tax returns, or other financials of a company being considered without question, but instead does some investigation to learn what the figures truly represent.
Some typical add backs to net income that are recognized without question by SBA lenders include:
- owner’s annual salary
- payroll taxes for the owner-manager
- owner’s pension
- owner’s health insurance premium
- amortization
- depreciation
- interest expense (typically for loans that will be paid off when the business is acquired)
- one-time business expenses (an expense the new owner will not have in the future)
- salary expense for family members who don’t actually work daily in the business
The above items are discretionary because either the owner decides the amount to be paid or the expense is solely for the owner’s benefit.
In addition, there are many other potential adjustments, such as:
- owner’s personal auto expenses (lease, insurance, gas, repairs, etc.),
- charitable donations, reduction or addition to fair market value for rent paid to owner(s)
- owner’s personal life, health, and disability insurance
- non-business meals and entertainment
- non-business travel
- non-business telephone and internet
Buyers and sellers should note that SDE works both ways. For example, if the owner-manager’s family member works in the business but is receiving no pay or less-than-fair-market-value pay, then the new owner will have to pay more for a replacement employee and that needs to be deducted from the SDE.
Proper calculation of SDE is vital to both sellers and buyers. For example, a business showing a “profit” of $140,000 could easily have an actual SDE of $400,000; that’s a huge difference in business value. An experienced business broker is the best resource for a thorough analysis and explanation of add backs and SDE.
Dave Driscoll is president of Metro Business Advisors, a mergers & acquisitions, valuation and exit/succession planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at [email protected] or (314) 303-5600. www.MetroBusinessAdvisors.com
As seen in Dave’s St. Louis Small Business Monthly column
