If you’re a small business owner considering selling your e-commerce venture, there’s one term that you’ll need to become familiar with, it’s Seller’s Discretionary Earnings (SDE).
Business brokers have a system which determines how much your business is worth. Rather than guessing and they use this to quickly calculate your estimated business worth so we can now explain the question that all businesses that are looking to sell want to know; “How much is my business worth?“
The key to getting the best valuation for your business is by understanding SDE and optimising it. Let’s have a look at SDE and explore how it can influence your business’s valuation so you are prepared and have a better idea on how to value your business properly.
The Essence of SDE: More Than Just Profits
SDE or Seller’s Discretionary Earnings represents the money an e-commerce business owner can expect to pocket after all necessary business expenses have been settled. It’s not just about net profit like many people base their business valuation on; it includes properly understanding seller’s discretionary earnings and expenses and gives you a holistic view of your financial health.
Using SDE means that business brokers can compare businesses in the same industry easily without owner’s compensation getting in the way and skewing the results.
To illustrate this better, consider the owner’s salary. It’s included in the business expenses, thus becoming non-operating income and lowering the net profit. However, since the owner’s compensation is the beneficiary of this salary, this figure is factored back into the Seller’s Discretionary Earnings (SDE) calculation. By doing so, it offers a truer picture of the business’s earning potential.
Why Should You Care About SDE?
SDE is a critical small business valuation tool that potential buyers consider when assessing a small business. It gives them an idea of the actual net income that they can expect if they decide to purchase.
But it’s not just important for potential buyers. A high SDE can indicate a healthy business and consequently attract a higher selling price for you. Understanding Seller’s Discretionary Earnings (SDE) can illuminate hidden business value, enabling you to make strategic decisions to increase your profitability and business value and not be caught out when someone who knows about SDE uses this to try and take advantage by offering you a lower price for acquisition.
SDE Versus EBITDA: A Crucial Distinction
EBITDA, standing for Earnings Before Interest, Taxes, Depreciation, and Amortization, is a widely used metric to assess a business’s financial performance. Unlike net income, it focuses on the business’s operational performance by excluding interest expense, income taxes, and non-cash expenses like depreciation and amortization.
EBITDA is often compared to Seller’s Discretionary Earnings (SDE), particularly when discussing small business valuations. SDE takes into account the owner’s salary, payroll taxes, and other discretionary expenses that are typically incurred by small businesses. These may include personal expenses such as the owner’s health insurance, as well as one-off or non-recurring expenses such as a significant marketing campaign or bad debt.
Calculating SDE can provide a more accurate picture of a company’s real earning power, especially for a potential new owner. Business brokers and prospective buyers often prefer this measure as it reflects the cash flow a business generates, adjusted for certain expenses and owner’s compensation. EBITDA and SDE can both be used to help determine a business valuation, but they are used for different scales of businesses. EBITDA is more common for middle market and larger companies, while SDE is typically used for small businesses and owner-operator type models.
In summary, both EBITDA and SDE provide important insights into a business’s earnings and are primary factors to consider when evaluating a business’s worth.
Unlocking Your SDE: A Simple Calculation? Maybe not!
Understanding Seller’s Discretionary Earnings (SDE) is pivotal for both sellers and prospective buyers during business valuation, particularly for small businesses and those in the middle market. The SDE calculation is a crucial factor in illustrating a business’s earnings and financial performance.
The SDE formula is relatively straightforward: it’s essentially the business income, less non-essential expenses or discretionary expenses. However, these discretionary expenses encompass a range of costs that could be adjusted under a new owner’s direction. Notable among these are the owner’s salary or owner’s compensation, payroll taxes, interest expense, personal expenses, and costs related to the use of a home office or company vehicle. Some less apparent inclusions might be one-time expenses, non-recurring expenses, and non-cash expenses like charitable contributions and business travel expenses.
By subtracting these discretionary expenses from the company’s net income, you’re essentially calculating the cash flow or owner cash flows generated by the business—hence why it’s also often referred to as owner-operator net profit. The advantage of this approach is that it provides a more accurate picture of the business’s profitability. If you’re in the same industry or have the same job function, this number can be an excellent comparison point between your business and similar businesses.
While it’s true that you could calculate SDE on your own, the risk of overlooking potential add-backs is significant. Therefore, it may be advantageous to work with a business broker or a professional accountant that understands SDE and specialises in small business valuations. They will not only ensure that all relevant expenses, including less obvious ones like bad debt, health insurance, and income taxes, are accounted for, but also they can help guide you through the broader process of understanding the seller’s discretionary earnings (SDE).
Moreover, the SDE metric is not the only metric used for business valuation. It’s often used in conjunction with other indicators like Adjusted EBITDA, free cash flow, and recurring revenue, depending on the nature of the business and the industry it operates in. Remember that non-operating income, intellectual property, and the ability to increase revenue and decrease expenses are also primary factors in a comprehensive business valuation.
Overall, calculating SDE is a vital step in assessing a business’s value and potential. An accurate SDE can fetch a higher multiple from prospective buyers, demonstrating a high SDE and, by extension, a well-performing company. Always ensure that for valuation purposes, all discretionary items, non-recurring items, and certain expenses are carefully considered in your SDE calculations.
Add-backs: What’s Not Included
While many expenses can be counted as add-backs, some cannot. Necessary expenses like the cost of goods sold, marketing and promotional expenses, sales tax, employee’s medical insurance, payroll taxes, travel expenses, and warehousing expenses aren’t classified as add-backs because a prospective buyer or new owner would need to shoulder these costs.
Boosting Your SDE: Strategic Moves
Enhancing your SDE should be a priority for every e-commerce business owner, given its direct impact on your bank account and small business valuations.
Boosting your SDE could be as straightforward as increasing sales volume through new product launches, expanding into new marketplaces, or ramping up marketing activity. On the flip side, it could involve judiciously cutting unnecessary expenses. Every pound saved not only improves your bottom line but also potentially multiplies your business’s sale price.
However, caution is necessary when making such changes, as drastic actions can hurt your business. A well-planned roadmap, possibly guided by a good exit planner, can help balance growth and cost-effectiveness for small businesses.
An SDE Story: The Case of YoYo Yoga
Let’s bring all these concepts together with an example. YoYo Yoga, an e-commerce business selling yoga mats, made £1,000,000 in sales last year. They spent £250,000 on the cost of goods, £100,000 on operational expenses, £120,000 on marketing, £100,000 on the owner’s salary, and some minor expenses on a car lease and charitable donations.
Initially, the company’s net income profit stands at £423,000. However, when calculating Seller’s Discretionary Earnings (SDE), we add back the owner’s salary, car lease, and the charitable donation, lifting the SDE to £530,000. This figure is a more accurate representation of the company’s value and would be more attractive to a potential buyer.
In conclusion, understanding Seller’s Discretionary Earnings (SDE) is an essential part of both selling and buying a small to midsize business. SDE, incorporating aspects like owner’s salary, payroll taxes, personal and non-recurring expenses, is the true reflection of a company’s net income. By focusing on the cash flow a business generates, the SDE provides a more detailed and reliable measure of a business’s financial health compared to net profit alone. The calculation of SDE, although seemingly straightforward, requires careful consideration of all discretionary expenses and items. Engaging the expertise of a business broker can help ensure an accurate SDE calculation, offering a more realistic picture of a company’s value, while preventing the risk of a potential buyer taking advantage of lesser knowledge about SDE.
Further, while SDE is a powerful tool, it’s not the only metric used for business valuation. Others like Adjusted EBITDA, free cash flow, and recurring revenue are also used, depending on the business and industry. The primary difference being their applicability to the scale of business, with EBITDA commonly used for larger companies, and SDE for smaller businesses. Understanding your company’s SDE is a primary factor in making strategic decisions to boost profitability, increase revenue, decrease expenses, and attract prospective buyers with a higher multiple.
An accurate SDE calculation ultimately unlocks your company’s true value, enabling a well-performing business to command a better price in the marketplace. Remember that intellectual property, the ability to increase revenue and decrease expenses, along with non-operating income, also contribute to a comprehensive business valuation.
Always ensure that for valuation purposes, all discretionary items, non-recurring items, and certain expenses are carefully considered in your SDE calculations. It is a critical instrument that illuminates hidden business value and aids in comparing your business to similar ones within the same industry or with the same job function. A strong understanding of SDE acts as a stepping-stone towards the successful selling of your business, potentially boosting your selling price, and setting you apart from other businesses in this competitive marketplace.
Next Steps – How we can help you
As specialists in e-commerce accounting, ‘Your Ecommerce Accountant‘ is well-versed in the financial performance of businesses operating on platforms like Amazon, eBay, and Etsy. Our expertise doesn’t stop at crunching numbers or helping you calculate SDE; we go beyond that. We empower you to fully understand how SDE is calculated and how it impacts your business’s earnings. Our team can help you identify ways to increase your company’s net income and enhance your business valuation through strategic planning.
Here at Your Ecommerce Accountant, we offer a free 30-minute consultation to anyone looking to sell their e-commerce business. Our experts will help you understand how to maximise your Seller’s Discretionary Earnings (SDE) and get the best value when selling your business. To book your free consultation, just click the Book Now button below. Get the upper hand in your business negotiations by understanding SDE in-depth and ensuring no prospective buyer takes advantage of your hard-earned business value.
It’s time to put your Seller’s Discretionary Earnings (SDE) to work for you. It’s time to unlock the real value of your e-commerce business. It’s time to partner with ‘Your Ecommerce Accountant’.
Book Now and start the journey to optimize your business value today!