What is SDE – Business Cash Flow
What is SDE? SDE stands for Seller’s Discretionary Earnings. This term is also referred to as adjusted cash flow or business cash flow. In short, SDE is the monetary value (in dollars) the owner(s) receive for owning the business. It is the small business equivalent of EBITDA.
Mid-size and large businesses typically use EBITDA when comparing businesses. EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. These larger types of businesses typically have multiple owners and investors. These owners and investors use EBITDA as a measuring tool for business profitability. EBITDA provides investors with an apples-to-apples comparison figure.
Small businesses are typically owned by one or two individuals. There is no mandate for how a small business reports its financials. This gives owners lee-way on how it categorizes expenses and how they pay themselves. Because this is true, it is difficult to use EBITDA to compare small businesses. SDE provides an apples-to-apples comparison between small businesses.
Being a small business owner provides many tax benefits to the business owners. As an example, if an owner buys a vehicle through the business, the entire purchase price can be deducted (called a Section 179 deduction). Owners dictate how much of their pay is salary versus profit as a way to lower payroll taxes.
A business owner may also have the business pay for certain personal benefits like health insurance. They could have the business fund retirement plans on their behalf. If they show ‘business purpose’, car insurance, car repairs, fuel, cell phones and travel can be expenses. We’re not saying it’s right or wrong, or providing tax advice, but the reality is that it does happen.
SDE or business cash flow takes all of these ‘expenses’ into consideration. SDE is the sum of profits, owner salary, owner benefits, and one-time expenses together. It also normalizes expenses like rent (if owner owns building) and salary figures for family members. Complete this for several businesses and you can compare companies fairly.
Business buyers care about seller’s discretionary earnings because it tells them what they would earn if they owned the business. This adjusted cash flow figure allows them to calculate the expected profits from the business. Business cash flow allows them the money needed to pay back employees, purchase equipment and grow. If buyers look at two similar businesses, they use business cash slow (SDE) to determine which business is ‘better’. Banks often also will use a similar SDE figure when underwriting a loan to purchase a business.
We often get asked, how is a small business valued. A small business is valued by calculating the SDE, multiplying the SDE by the correct multiple and adding hard assets. The most difficult part of most business valuations is determining the correct multiple. Mid-size and large businesses multiples vary greatly by industry. For small businesses, determining the multiple is far simpler. (If you’d like a detailed walk-through of small business valuations, refer to our ‘how a small business is valued’ page.)
Below are the four steps in calculating SDE (business cash flow) for a business. To calculate the SDE, you’ll need the profit and loss statements or taxes. At a minimum, we suggest having the profit and loss for the most recent trailing twelve months (TTM). By calculating SDE for several years, you’ll be able to spot growth trends in profit. The process will seem difficult once you read, but a spreadsheet will simplify things. If you’d like we will email you our free SDE Worksheet to expedite the process.
The first step is pretty straight forward. Take the net income from the business and add back interest, taxes*, depreciation and amortization expenses. Then add the primary owner’s salary and payroll taxes. This provides the adjusted EBITDA for the business. (*As a side note, most small businesses ignore the ‘taxes’. This ‘taxes’ refers to business income taxes paid and typically only applies to C Corporations. It does not refer to payroll or sales taxes paid.)
Next, review the financial statement for discretionary expenses. Discretionary expenses are those an owner doesn’t deem as necessary to run the business. Examples include owner related expenses such as owner retirement contributions, insurance, donations, and travel expenses. If a buyer ever examines these, you’ll need to defend these add-backs. As much as it makes sense, be realistic and conservative with the add-backs.
In the event there are multiple owners or family members working for the business, adjustments need to be made. Perhaps an owner’s spouse works for free for the business. A new owner would have to pay someone to fill that role so it needs to be accounted for. Take the expected salary needed to replace that person and subtract it (not add). If there are passive owners who receive salaries, those salaries should be added back as well.
Lastly, review the financials for any other adjustments that need to be made. In the event the business owns the real estate and doesn’t pay ‘rent’, a rent adjustment needs to be made. When the owner owns the building and charges rent, adjust to reflect market rates. If a relative is unnecessarily on payroll for tax purposes, adjust for that. In the event of a one-time expense or revenue, adjust for those.
If an owner wants to maximize the value of a business for sale, special attention should be given to SDE. This business cash flow figure, if overlooked, reduces business price by tens or hundreds of thousands at time of sale. Most buyers expect there will be add-backs. If an owner skips these add-backs, it is unlikely a buyer will point it out for them. Be conservative and realistic when calculating the seller’s discretionary earnings.