SDE - Inside the Cake

The Real Deal Behind Seller's Discretionary Earnings (SDE)

When buying a small business, one of the most common ratios buyers focus on with their search is the Seller's Discretionary Earnings (SDE).

SDE is a key metric representing a single full-time owner-operator's total financial benefit from the business. It includes:

- Net income before taxes

- Owner's salary

- Depreciation and amortization

- Interest expense

- Non-recurring expenses and income

- Owner perks and benefits

SDE is crucial because it helps buyers assess the cash flow they can expect from the business, guides them in valuing the company, and informs their purchase decisions.

However, there are some downsides and caveats buyers must recognize:

1. Owner's Salary

- Pros: Including the owner's salary in SDE gives a clearer picture of the total earnings.

- Cons: This amount is often immediately paid out to the new owner, meaning the actual cash benefit isn't as high as it appears.

2. Depreciation and Amortization

- Pros: These non-cash expenses are added back to show true cash flow.

- Cons: Overlooking necessary future capital expenditures for replacing assets can lead to underestimated ongoing costs.

3. Interest Expense

- Pros: Adding back interest shows potential earnings without debt costs.

- Cons: Buyers typically need substantial financing, often through SBA-backed loans, to purchase the business. Sellers seem to forget this. Calculating the annual loan payments based on current interest rates can significantly reduce the actual cash flow.

4. Non-recurring Expenses and Income

- Pros: This adjustment helps to normalize earnings by removing one-time items.

- Cons: Determining what qualifies as non-recurring can be subjective, potentially artificially inflating SDE.

5. Owner Perks and Benefits

- Pros: Adding back personal expenses charged to the business paints a clearer earnings picture.

- Cons: Some perks might be necessary for business operations or maintaining relationships, meaning they aren't truly discretionary.

While SDE can look enticing, much like the icing on a delicious cake, buyers must examine these numbers more closely.

Recognizing these potential pitfalls ensures a more accurate assessment of the business's financial health.

Always perform thorough due diligence and consult with a business acquisition SBA loan consultant to avoid unpleasant SDE surprises.

Investing time in understanding the nuances of SDE can make a significant difference in the success of your business acquisition journey.

Feel free to reach out if you have any questions or need guidance on your business acquisition journey. Let's ensure you make the best decision for your future success.

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Deb Curtis is a dedicated ally for business buyers, prequalifying and sourcing the best SBA-backed loan projects. With an extensive background as an SBA lender previously employed by various banks and non-bank lenders, she saw the need for a positive change in Main Street business acquisition lending to protect buyers.

Frustrated by banks' credit policies and politics, she founded her consulting firm in 2018. Known for her integrity, loyalty, and transparency, Deb focuses on quality over quantity in business acquisition loans, ensuring seamless ownership transitions for her clients.

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