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SDE: Seller’s Discretionary Earnings. What Exactly is It?
By Mark Daoust
If you have browsed online businesses for sale, you have likely run across one of the following terms:
- DCF: Discretionary Cash Flow
- SDI: Seller’s Discretionary Income
- SDCF: Seller’s Discretionary Cash Flow
- ODI: Owner’s Discretionary Income
- ODCF: Owner’s Discretionary Cash Flow
Most people are able to quickly gather that this term speaks to a business’s profits in some way, but what exactly is this number trying to represent, and why is it important?
Why You Should Understand SDI
If you want to predict the value of an online business for sale, you typically need to start with that business’s discretionary earnings.
Understanding owner’s discretionary cash flow is important because the vast majority of website appraisals performed by brokers and buyers alike are based on a seller’s discretionary income.
For buyers, understanding seller’s discretionary income can help you more accurately predict and understand your potential return on investment. The goal of presenting an SDI number is to provide you with an understanding of the realistic earnings of any particular business.
For sellers, understanding seller’s discretionary income enables you to potentially maximize the value of your business before you sell. In addition, as you prepare your business for sale you will be presented with various expenses that may or may not impact your overall valuation. A proper understanding of SDI will enable you to make the right decisions in your preparation.
What is Discretionary Cash Flow?
A seller’s discretionary earnings are the pretax and pre-interest profits before non-cash expenses, one owner’s benefits, one time investments, and any non-related income or expenses. In addition, SDI may require that expenses be adjusted if a new owner will necessarily need to take on a new expense.
Let’s break this down into each of its parts:
- Pretax and pre-interest profits before non-cash expenses. This is EBIDTA, the accounting terminology for earnings before interest, depreciation, taxes, and amortization.
- One owner’s benefit. Standard in the calculation of SDI is the “add-back” of one owner’s compensation. If there are multiple owners who actively participate in the operation of the business, part of the calculation of SDI requires that a projection be done to replace the other owner’s efforts and work.
- One-time expenses. This would include major website redesigns, acquisition of specific licenses, one time application fees, etc.
- None-related business expenses or income. Common scenarios would be taking consulting income and running that through your e-commerce business, taking extra time on a business trip for a personal vacation, charging your business “rent” for a home office, running an automobile expense through your business when your business does not require an automobile, etc.
- Adjusted expenses. Consider a company that owns a large fulfillment center and a small website they operate out of that same fulfillment center. Any company acquiring this small website will need to account for the expense of warehousing and filling orders. This expense will need to be injected into the overall earnings statement of the business.
The ultimate goal of identifying a seller’s discretionary earnings is to properly identify what a new owner can reasonably expect for annual earnings. Often times this calculation can involve a bit of an art or understanding, and it is not uncommon for a buyer and seller to disagree about what is being included – or not included – in their discretionary earnings number.
Common Areas of Disagreement
It is not uncommon for buyers and sellers to disagree about what should be included in a discretionary earnings number. Often times these disagreements come about because discretionary earnings is not really understood, but there are areas where a buyer and a seller may simply see an expense, an earning, or a replacement value in a different light.
Areas that are common to disagreements between buyers and sellers are:
- Replacement owner’s benefit. In the case that there are multiple owners who are actively working on a business, only one owner’s benefit can be added back into the earnings. For the other owners, their earnings should be adjusted to represent reasonable market rates. For example, if there are two owners of a business, one does the marketing and customer service while the other handles all order fulfillment and both are working full time, one of the owner’s benefits can be added back into the earnings. Let’s supposed we add back the benefit of the owner who handles marketing and customer service. The owner who handles all order fulfillment should have his or her earnings adjusted to what it would cost to replace that owner with a full-time worker doing that same job. Buyers and seller’s can disagree over this as they may disagree on the actual scope of the work or what is a reasonable rate to pay someone to replace that owner.
- One-time expenses. Some one-time expenses are easy to justify such as a one-time application fee or licensing fee. Other one-time expenses can be disputed if the buyer and seller do not agree that it is indeed a one-time expense. For example, major website redesigns and upgrades are typically added back into earnings as they are not ongoing costs. However, it is also reasonable to suppose that a site will need to be periodically upgraded and redesigned. However, since the choice to upgrade and redesign is typically done at the owner’s discretion, it is typically an added-back expense.
- Adjusted Expenses. In the section above, I used the example of a fulfillment center that utilizes some of its space and workforce for a small web business. In calculating the total seller’s benefit, a replacement cost will likely need to be injected into the earnings statement in order to properly represent potential earnings. Buyers and sellers may disagree over the reasonableness of that replacement cost. On the other side, a seller may argue that injecting a replacement cost is not necessary. For example, using our example of a fulfillment center, if the amount of space and workforce necessary to fill orders could easily be run from a home office, then a seller may argue that a replacement cost is not necessary.
Discretionary Earnings will Vary from Buyer to Buyer
The purpose of focusing on a seller’s discretionary earnings is to provide a consistent number that can be used as a baseline for a buyer to make their own calculations and estimates as to how much a business will earn for them. Each buyer will have their own set of circumstances and expenses which will adjust that final earnings number.
For example, some buyers intend and plan to outsource 100% of the work in a business. As such, they will need to inject an expense for whatever work the seller is currently doing for the business. Other buyers may have no intention of ever housing inventory even though the current owner of a business is able to comfortably do so out of their home. That buyer will need to plan for an added expense.
Because a buyer’s situation will necessarily change from one buyer to the next, we focus on the seller’s income that they have at their discretion.