When you're considering acquiring a business as part of your growth strategy or succession plan, you'll encounter numerous financial terms and acronyms. While you may be familiar with common business terms like COGS (Cost of Goods Sold) or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), there are acquisition-specific metrics that are equally important to understand. One of the most critical is SDE – Seller Discretionary Earnings.
At GWCPA, we believe that building a multi-generational business legacy requires making informed decisions at every stage of your business journey. Understanding SDE is essential when evaluating a potential business acquisition, as it provides a clearer picture of what you're actually buying.
What Exactly Is Seller Discretionary Earnings?
Seller Discretionary Earnings represents the true operating cash flows available to a business owner after accounting for revenue, cost of sales, and overhead expenses. Unlike EBITDA, which is used in day-to-day operations, SDE is specifically designed to help potential buyers understand the actual financial benefit they might receive from acquiring a business.
Starting with operating net income, SDE typically adjusts for:
Owner's salary and benefits
Personal expenses run through the business
One-time or non-recurring expenses
Discretionary expenses that may not continue under new ownership
Calculating SDE: What Gets Added Back
To calculate SDE, you start with the business's EBITDA and then add back various discretionary expenses that the current owner has chosen to run through the business. These might include:
Owner's compensation and benefits
Family members on payroll
One-time legal or other non-operating expenses
Personal vehicle expenses
Cell phone plans
Excessive travel or entertainment expenses
Charitable donations
Other personal expenses run through the business
These adjustments help reveal the true earning potential of the business under new ownership.
Why SDE Is Better Than EBITDA When Buying a Business
SDE provides a more accurate picture of what cash flow will be available to you as the new owner. This is crucial because this cash flow must:
Fund necessary capital expenditures for continued growth
Service any debt you take on to acquire the business
Cover your tax obligations
Provide your compensation or distributions
Understanding SDE helps you determine if the business can realistically meet these financial demands while still providing the return on investment you're seeking.
Looking Beyond the Numbers: Quality of Earnings
When evaluating a business acquisition, we recommend looking beyond a single year's SDE. A Quality of Earnings (QoE) analysis would examine:
3-5 years of financial data (ideally)
Growth patterns in both revenue and SDE
Comparison between financial statements and tax returns
Potential capital expenditure requirements
Non-ordinary events, e.g. Pre-COVID, COVID, and post-COVID performance
This deeper analysis helps reveal whether recent performance is sustainable or if there are underlying issues that might affect future earnings. At GWCPA, we can provide a buyer's side Quality of Earnings report for a potential acquisition to help you make your decision. Our team is dedicated to multi-generational succession planning, helping you understand metrics such as SDE so you can make informed decisions that will continue to build on a solid foundation.
Moving Forward with Confidence
The due diligence period in business acquisitions can move quickly—often just 30-45 days between the Letter of Intent (LOI) and the final decision. Having a clear understanding of SDE and an accompanying Quality of Earnings report can help you move forward with confidence, knowing you understand the performance of the business you're acquiring.
