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Calculating Seller Discretionary Earnings Correctly

Calculating Earnings Photo

What’s the first question the Buyer asks about buying your business? Usually, it’s “how much can I make if I own this business?”  For main street businesses, those business for sale transactions under $1,000,000 in transaction value, usually the Buyer is looking for “Sellers Discretionary Earnings.”

Seller’s Discretionary Earnings (SDE) is usually calculated as follows:

  • Net profit of the business, plus
  • Officer or Owner Salary, plus
  • Owner Perks such as country club memberships, etc., plus
  • Interest, depreciation, and amortization, plus
  • One- time extraordinary expenses

Here are 6 things to look out for when calculating seller discretionary earnings:

  1. The Owner’s salary can only be included if the Owner paid themselves through the business and expensed it on the income statement or tax return. Owner draw CANNOT be counted.
  2. Only ONE owner’s salary can be included. If there is more than one owner, or family members working in the business, a fair market wage must be included in the expenses.
  3. Only those Perks that do not impact the business can be adjusted. For example, if your customers rely upon the owner taking them out to dinners or sporting events, and without those perks, you could lose the business, then those must stay with the business. Same with the owner’s automobile expenses if they go to see clients, pick up things at Costco, make deliveries, etc.
  4. Usually, most interest can be “added back”, but not interest that will stay with the business after the sale. For example, interest costs on vehicle loans not being paid off at closing, flooring interest for businesses with large amounts of inventory, etc. cannot be adjusted out.
  5. Depreciation costs are usually an adjustment, but consideration must be given to those businesses with assets that depreciate quickly and are costly to replace. For example, a business with a fleet of 10 trucks and on average, a truck will last 10 years, you need to consider leaving in enough depreciation to cover the cost for one truck being replaced each year.
  6. One-time expenses are just that—ONE TIME. These can be items like the cost to design a new company logo which may never be done again. Or to rebuild a storage shed after a fire that was a once in a lifetime occurrence. It is NOT the cost to replace the carpet in a restaurant that traditionally is replaced every three years. (you could amortize that cost over the useful life instead of it impacting one year in particular)

They say that the devil is in the details. Every business is different, so buyers and sellers really need to use common sense and fairness in calculating Seller’s Discretionary Earnings. And buyers need to remember, this is the SELLER’s Discretionary income, not Buyers! SDE is a snapshot of the Sellers operation, and how the buyer operates the business will determine THEIR SDE.

Are you looking to buy or sell a San Diego business? Vanguard Resource Group can help with calculating SDE. Learn more about our expert Business Valuations.
Contact us today! 

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