Valuations of small to medium sized businesses can be complex. When we provide a valuation report to a vendor client, we consider multiple complex valuation methods and use a weighted average to come to an estimated value for the business. However, one method that is always used, and which usually composes the largest weight of any method used in the valuation, is the SDE market comparison method.
SDE stands for Seller’s Discretionary Earnings. This is a measure of profits that excludes certain debt expenses, as well as expenses that, well, are considered discretionary and not crucial to the functioning of the business. SDE is an alternative to Earnings Before Interest, Taxes, Debt and Amortization (EBITDA). That is because, in the realm of small and medium sized businesses, expenses relating to personal or non-business use are more common, but these items should not detract from real profits for the purpose of valuation. So, what does SDE consist of? Here’s how it is calculated:
First, we take Pre-Tax Profits, then we subtract the interest expense on long term debt, depreciation expense and amortization expense because companies are generally sold debt-free.
Then we subtract non-recurring expenses because those don’t represent a fair account of the profitability of the business. If capital injections are required periodically, we adjust for those.
Then, we subtract the aforementioned discretionary expenses, also known as fringe benefits, that do not contribute to the operation of the company. These are often expenses made for tax or other peripheral purposes, such as a car for the owner that is not integral to the business, etc.
If the company owns the real estate in which it operates, we assume the buyer is buying the business only and add a rent expense estimating the yearly market rate for rent of the space currently being used.
The salary that an owner takes to manage or operate the business forms part of the SDE and is not considered separately. If more than one owner’s salary needs to be replaced, we add back an appropriate salary for hiring a manager to complete the second owner’s job.
Once we have an accurate measure of SDE, we use multiple databases of data on previously sold comparable businesses to determine what ratio to apply to SDE to determine purchase price. This is a market comparison method.
That being said, this one aspect of the business valuation, and at VR we weight it against the other methods that vary depending on the type and characteristics of the subject business. If you are considering selling your business, please don't hesitate to contact me so we can complete a detailed valuation for you.