Earnings Defined, or How to Arrive at a Selling/Offering Price for the Business.
Businesses are acquired for their earnings or their potential for earnings. And buyers look at earnings when establishing a price they will pay for the business. Typically this is a multiple of earnings. So what are earnings and how are they defined? One measure is called Seller’s Discretionary Earnings or SDE.
Seller’s Discretionary Earnings (SDE)
As business brokers, we like to use the term Seller’s Discretionary Earnings to analyze the profitability of small businesses and to arrive at a consistent pricing mechanism for the business. We will often recast a seller’s P&L or tax statement to arrive at the SDE of the business, and as a buyer, you will want to do the same with the businesses that you are analyzing for a possible acquisition. SDE is the net profits of the business with addbacks of expenses that benefit the owners but do not necessarily benefit the business. The recast will show what benefit the owners are taking from the business. Addbacks include:
- Owner’s salary
- Personal insurance premiums for the owner.
- Wages paid to family members in excess of those wages needed to hire someone to do their jobs.
- Owners vehicles that are paid for through the business but not necessary to the business. This includes gas, tires and other repair expenses
- Personal expenses paid for through the business like medical bills and cell phones.
- Entertainment expenses in excess of that needed to maintain adequate marketing for the business.
- Large, one time expenditures for equipment, uninsured losses, major repairs or space buildouts that were expensed during the reporting period.
- Fines or penalties paid that would not necessarily be paid by a new owner.
- Subscriptions and organizational dues that are not necessary to the business operation or marketing.
- Prepaid expenses, usually prorated for the period.
- Depreciation Expenses
- Amortization Expenses
- Interest paid on long term notes.
Once the SDE is determined through the finanical recast, we have a value that then can be utilized by both Seller and Buyer in their negotiations.
Another earnings measure commonly used is the EBITDA. But that’s for another blog.