What’s the first question the Buyer asks about your business? Usually, it’s “How much can I make if I own this business?” For Main Street businesses, transactions under $1,000,000 in transaction value, the Buyer is usually looking for “Seller 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
But the devil is in the details. So, make sure you don’t make the following mistakes:
- The owner’s salary can only be included if the owner pays themselves through the business and expenses it on the income statement or tax return. The owner’s draw CANNOT be counted.
- Only ONE owner’s salary can be included. If more than one owner or family member works in the business, a fair market wage for replacing the second owner must be included in the expenses.
- 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. It is the same with the owner’s automobile expenses if they see clients, pick up things at Costco, make deliveries, etc. Remember, anything that gets adjusted out must be able to be proven with documentation to both a buyer and the lender.
- 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.
- Depreciation costs are usually an adjustment, but consideration must be given to 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 of replacing one truck each year.
- One-time expenses are just that—ONE TIME. These can be items like the cost of designing 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. One-time expenses are NOT the cost of replacing the carpet in a restaurant that is traditionally replaced every three years. (you could amortize that cost over the useful life instead of it impacting one year in particular)
Every business is different, so buyers and sellers need to use common sense and fairness when computing SDE. Buyers must remember that this is sellers’ Discretionary income, not buyers’! SDE is a snapshot of the Seller’s operation, and how the buyer operates the business will determine their actual SDE.
When you buy or sell a business in Southern California, professional business brokers, especially Certified Business Brokers through the California Association of Business Brokers, can help you understand the true cash flow of a business. Vanguard Resource Group is the leader in private business sales in San Diego County and has sold over 800 businesses. Please reach out should you or someone you know be interested in discussing the sale of a business.
