Historical Cash Flow Analysis and Seller Discretionary Earnings (SDE)
When assessing the value of a small business, analyzing historical cash flow is a fundamental approach. This method provides buyers with insight into the company’s annual revenue generation and often justifies a premium purchase price for businesses with a proven track record of success.
However, many business owners collaborate with their accountants to minimize net profit and reduce tax liability. While this strategy is understandable, it conflicts with buyers’ primary focus—profitability.
To bridge this gap, an adjusted financial analysis is frequently employed: Seller Discretionary Earnings (SDE). This widely used method in business brokerage adjusts the Profit and Loss statement to reflect the seller’s compensation and benefits, ultimately revealing the true cash flow potential of the business.
Understanding SDE vs. EBITDA
SDE is comparable to another key financial metric, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):
EBITDA Formula:
EBITDA = Net Earnings + Interest + Taxes + Depreciation + Amortization
This calculation removes the current owner’s debt structure, tax strategies, and non-cash expenses, thereby presenting the company’s core cash flow.
Since a new buyer’s capital structure will likely differ, EBITDA serves as a more standardized profitability measure.
SDE Formula:
SDE = EBITDA + Seller Salary + Other Discretionary Expenses
SDE accounts for the owner’s discretionary compensation, which can take multiple forms. The seller’s salary is included because it pertains to the individual owner, while a buyer’s salary expectations may differ. Identifying which expenses are truly discretionary versus necessary business costs is a critical step in this analysis.
Common Add-Backs in SDE
Typical discretionary expenses that are added back in SDE calculations include:
- Owner retirement contributions
- Spouse/family wages (when roles are discretionary or minimal)
- Personal vehicle expenses
However, this is not a one-size-fits-all approach. For example, if a personal vehicle is essential for job site visits or if a spouse serves as the full-time bookkeeper, these costs should be classified as legitimate business expenses rather than discretionary ones.
Excessive personal expenses routed through the business may not always qualify as valid add-backs. Business owners may be reluctant to disclose certain personal expenses—such as a home basement remodel—which are typically excluded from SDE calculations.
The Impact on Business Valuation
Every business is unique, and a careful examination of cash flow calculations is essential, as these directly impact a business’s valuation and purchase price. Accurately adjusting for discretionary earnings ensures that buyers and sellers have a clear, realistic understanding of the business’s financial health.
In Parts 2 and 3 of this series, we will explore additional valuation considerations and strategies for maximizing a business’s worth in the sales process.
