Is Seller’s Discretionary Earnings (SDE) Still Relevant in Valuing Small Businesses Today?

TrendsIf you own a business  you are probably familiar with the acronym EBITDA.  To be clear, it stands for Earnings Before Interest, Taxes, Depreciation and Amortization, and is used to show an investor how much a company is earning.  Seller’s Discretionary Earnings (SDE) is a similar measure of earnings, but used to present earnings for smaller companies, generally less than $1 million in revenue.  SDE has been the standard measure for businesses that have an active owner–operator and used by the business brokerage community for decades.  The difference between EBITDA and SDE is the inclusion of a manager’s salary in EBITDA.  A buyer considering an acquisition opportunity who wants to be an “active” owner-operator must adjust SDE for their own compensation. But this is where current market trends may require a change of practice from the business brokerage community.  I have seen enough evidence recently to suggest that presenting SDE to most buyers today might even be an irrelevant earnings calculation. Keep reading to understand why this might be an antiquated practice.

At Romaco Group, we personally interview every buyer that takes the time to return the client’s Confidentiality Agreement. We never skip this step because it gives us critical insight into the buyer’s expectations, experience level and industry knowledge.  In our office, countless buyer interviews have started with the same basic question: “Are you interested in being an active owner-operator, or looking for a passive business investment?”  Ninety-nine times out of a hundred, the answer is “active owner-operator”.  The very definition of “active” is where things get interesting, and I suggest fundamentally different from one generation to the next.  Not taking a buyer’s definition at face value, we go on to ask buyers to describe their vision for “active” involvement in the target company.  The buyers’ descriptions of “active” rarely match up with our client’s description of their daily responsibilities in the business. Today’s buyers and our seller clients both use the term “active ownership”, but are worlds apart in interpretation.

The majority of buyers we’ve interviewed in recent years see themselves in a (active) strategic planning role, wanting to navigate the direction of the company, but expecting key team members and a full staff to execute on those initiatives.  Buyers in today’s market put emphasis on work-life balance – an elusive notion for most Baby Boomer business owners.  Most buyers weed out opportunities that require them to be a slave to the business, making it a challenge to sell a business whose success depends on the daily involvement of its owner.  If this isn’t enough to keep you up at night, the conservative nature of today’s buyers (and lenders) should.  On the heels of the Great Recession, the scrutiny of due diligence and the loan approval process make an IRS audit seem downright mundane.

So what does this mean for those that are considering selling a small business?  If you are relying on the sale of your business to fund all or part of your retirement, the price a buyer is willing to pay you for your company may come as a real disappointment.  Buyers may be using EBITDA to value your company, while your transaction advisors may be using antiquated practices when setting your expectations using SDE. Offers you receive may have an adjustment for compensation to add a person or manager to handle some of your responsibilities – freeing the buyer up to focus on the overall direction of the company. Let’s suppose you are lucky enough to negotiate purchase price and terms that both you and the buyer agree to.  The question still remains whether your daily level of involvement or technical ability creates a hurdle that is insurmountable for a potential buyer.  A buyer must be able to visualize the transition and your eventual exit – sooner, rather than later.  If that’s not clear, be prepared to stick around after the sale or accept a lower price for your business.  And unfortunately, even that might not be enough to guarantee a successful transaction.   The market is ever changing and you’ve worked hard to keep up with changes in your industry to maintain profitability.  When it comes time to sell your business, make sure you surround yourself with transaction advisors that keep up with the times as well. Selling your business is likely to be the most important transaction of your life.