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What is Sellers Discretionary Earnings ("SDE")?

"In the business world, the rear-view mirror is always clearer than the windshield."

Warren Buffett, Berkshire Hathaway, Chairman

cash flow image women writing on whiteboard

 

 

 

 

The purpose of the Seller Discretionary Earnings ("SDE") statement is to give potential buyers a better understanding of a company's economic worth and to guide valuation based on cash flow. 

In my role as a business broker, an important element of the job is to explain the financial side of a business to buyers. The great majority of our listings are bought because the business is already generating profitable cash flow, the business has clients, existing vendor relationships and most importantly a loyal and dedicated staff.

Since I'm asked so often about the Seller Discretionary Earnings statements found in our Confidential Offering Memorandums this post is a quick primer on the subject.

The buyer wants an asset sale in order to step up the tax basis of the assets, while a seller wants a stock sale to avoid the double taxation (taxation on the asset basis and the stock basis).
— Jim Peddle, Business Broker

First, there are certain assumptions a business broker will make in the SDE including;

  • Asset sale - Buyers will acquire a business and the assets via an asset purchase agreement with the Seller. The SDE does not include Cash, Accounts Receivable and Accounts Payable.

  • Debt free business - A buyer usually does not assume any of the Seller's debt and there are no interest payments calculated in the SDE.

  • A new owner will be a hands-on participant in the business and a full-time owner of the business post-closing. A very important point as absentee owners pay less for a business because they will need a full-time manager to run the business which lowers the price they will pay due to added payroll costs post-purchase.

  • Current owner may have received benefits in various forms. The SDE converts the expense to cash and its called an addback. We recommend buyers review the numbers with the business broker who represents the seller.

  • Financials ideally are taken from the company's filed federal tax returns. However, Buyers should compare internal statements that may be on a cash basis and not accrual.

 

 

Things to consider when reviewing the SDE

  • The SDE is a financial report created from the business tax returns provided by the Seller to potential buyers after an Non-Disclosure Agreement is signed.

  • Add-backs are taken from expenses already listed in the financials, there should be verifiable proof of any of the expenses considered an add-back.

  • There may be big differences between Internal profit and loss statements and Tax Returns, compare apples to apples.

  • Confirm expenses are up to date - If business is behind on accounts payable (bills) the expenses are understated. Very important due diligence point!!

  • Depreciation is seldom listed in the internal profit and loss but shows up in the tax return filing.

  • Equipment leases - Is seller paying off the lease and transferring equipment debt free?

  • Schedule M-1 on tax return reconciles books to tax returns, may explain personal expenses paid by the business which were not included on the Tax Return.

  • Be aware of the difference between distributions taken out of business vs. cash generated by the business.

  • Owner salary is a W-2 payment to seller, profits are paid out as distributions or dividends.

  • Rent - Is the business paying fair market? If not, adjust this in the SDE calculation.

  • Is the seller the owner of the real estate? Review the utility bills and other facility cost expenses.

  • Rent- If the real estate is being sold along with the business, use a 25-lyear mortgage payment and adjust if the payment is less than the market rent.

So what are common add-backs in small market mergers and acquisitions?

  • Non-cash expenses - depreciation and/or amortization

  • Non-recurring expenses - bad debt expense, website development, sale of any excess equipment, late fees, facility expenses such as new carpet, painting.

  • Non-operating expenses - Bank mortgage interest, credit card interest, interest expenses

  • Owner operator salary, bonus, dividends, K-1 - self explanatory

  • Other expenses which the owner receives in operating the business; Payroll taxes of owner, pension payments such as SEP plans, auto expenses and insurance, health insurance, professional fees, cell phones, Utilities, travel & meals, Other (Must be provable)

Common Areas Buyers - Sellers Disagree

Owners Salary - Is this an addback or not?

A business broker will add any and all compensation that is paid to an owner. Many buyers disagree with this math and will debate a business broker leaving no dollars to pay for a manager. Even though I understand the logic, I disagree excluding out any portion of the compensation an owner is paid from the business. These are small businesses and the owner doesn’t have the luxury of extra staff so they can work less than 40 hours a week. If a buyer chooses this option their offer will be less than a buyer who will work “in” the business.

Here’s an example of how a business broker captures all of the income paid to the owner;

SDE (With all compensation paid and included)

Salary $50,000

Addbacks:

Phone $1,000

Health Insurance $7,000

Payroll Tax Paid by Co. $4,350

Auto $7,000

Other $2,100

Distributions $125,000

Total: $196,450

Summary

Small Business acquisitions are very different than bigger middle market deals. Larger deals will often have audited financial statements due to bank debt and covenants that require timely reports. Buyers should take the time to fully understand the business financial statements given by the broker prior to making an offer for the business.

Allow Due Diligence as your opportunity to verify the expenses and revenue for three years. Speak to a qualified CPA that understands small business tax returns and accounting. It’s important that a buyer fully understand the financials so get comfortable and ask a lot of questions!

Feel free to contact Jim Peddle, Certified Business Broker, at 312-525-9622 or email president@playbookadvisory.com with questions related to selling or buying a business.