Seller's Discretionary Earnings Explained
Learn how to calculate the seller's discretionary earnings for your DTC brand and why it's so important for your business.
Navigating an ecommerce business isn't easy.
There is no treasure map with a large X telling you exactly which way to go. But there are indicators, 'clues' in a way, that help you understand where your business is today and where it can go in a month from now, a year from now, and 5 years from now. These indicators also help potential investors or buyers understand the value of your ecommerce brand.
One of these indicators is called seller's discretionary earnings (SDE). Let's cover what SDE is, why you need it, and how to calculate it.
What is seller's discretionary earnings?
Seller’s Discretionary Earnings is a way of "normalizing" the earnings of your business so you can compare your business to other businesses of similar sizes.
It starts with your net income and adjusts for certain income and expenses to calculate the financial benefit that a single, full-time owner-operator would get from the business on an annual basis. Usually, the calculation is based on the last full year of operations or the trailing twelve months (TTM) (i.e., the last 12 months from that date of the calculation).
For example, to calculate SDE in July 2022, you can either calculate SDE for the full 2021 year or you can calculate it for July 31, 2021 - July 31, 2022.
SDE is often also referred to as Adjusted Cash Flow, Total Owner’s Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings.
Why is SDE important?
SDE is often used in the valuation and sale of smaller businesses (less than $5 million in revenue). Larger businesses primarily use EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization) instead of SDE.
EBITDA and SDE are similar concepts. The main difference is that to calculate SDE, you also need to add back owner's compensation. In smaller businesses, owners may take money from the business in lots of different ways. One owner may take a salary throughout the year while another may withdraw everything left in the company at year-end.
Valuing a smaller business based on a multiple of SDE allows you to normalize the earnings so you can compare apples-to-apples across the different businesses, no matter how you or other owners have been compensating yourselves in the past.
To value your ecommerce business, a valuation expert would use multiple used for other similar ecommerce businesses that have recently sold and apply them to your SDE to get a value.
For example, if your SDE is $300,000 and you receive an SDE multiple of 2.5x, then the business would have an implied value of $750,000 ($300,000 times 2.5x). For ecommerce, the average SDE multiple is between 2.0x - 4.0x.
How do you calculate your seller's discretionary earnings?
To calculate your SDE, you start with your net income and make certain adjustments.
Here's the formula:
Net income (the bottom line profit on your P&L)
Add-back:
- Owner's compensation paid to all owners - salary, profit sharing, cash distributions, etc. less the salary of any employee that would be needed to replace 2nd or 3rd (etc.) owners.
- Employer portion of payroll taxes paid on the W-2 salary of one owner
- Interest expense
- Depreciation and amortization
- Taxes paid by the business
- Discretionary expenses (these are perks paid by the company that benefit the owner, such as car, cell phone, meals, entertainment, personal travel, etc.)
- Extraordinary, non-operating or non-recurring revenue or expenses (e.g., expenses from a lawsuit, flood damage, etc.).
SDE is different than cash flow in that it focuses on cash flow of recurring operating expenses, as opposed to cash flow itself which includes amounts used to pay off loans, capital expenditure purchases, or other extraordinary expenses.
You can check out Finaloop's SDE calculator to get an idea of what your SDE would look like.
What are discretionary expenses?
Discretionary items are expenses that the business paid but are really a personal benefit to the owner.
Examples of discretionary expenses include your medical or life insurance, personal travel, personal cars, personal meals/entertainment, and social club or gym memberships. To be considered a discretionary item, each expense must meet all four of the following conditions:
- It benefits the owner(s)
- It does not benefit the business or its employees
- It's paid for by your business and expensed on your business's tax returns and P&Ls
- It's documented and verifiable as a discretionary expense.
Discretionary expenses are often the subject of debate between a buyer and seller.
If you are looking to sell your business, keep in mind that buyers tend to be skeptical about these "mixed" expenses even if you claim they are not really expenses of the company.
Expenses that fall in a gray area of discretionary or not-discretionary may require extra documentation and due diligence for the buyer.
Whether you currently plan to sell your business or not, as a general rule, it is best practice to not pay personal expenses from your business accounts and to keep your books 'clean'.
What are non-recurring items?
The other category that needs to be added back to determine your SDE is extraordinary or one-time income or expenses.
Examples include restructuring costs, flood or hurricane damage, sale of an asset, legal expenses for a one-time lawsuit, etc. Adjusting for these extraordinary one-time income and expenses allows investors to see how the company is really doing on a regular, on-going basis.
The bottom line
Separating your personal (aka 'discretionary') expenses from your business expenses allows you to keep your books in better shape whether you plan to sell your brand or if you just want more visibility into the "real" earnings of the company.
Either way, using ecommerce bookkeeping experts, like Finaloop, to help keep your books clean will help you be ready for whatever the next steps are for your business.
About Finaloop
We are a technology company providing automated end-to-end accounting service to ecommerce businesses. Our system connects to your apps, syncs all your data and reconciles your books in real-time, replacing your bookkeeper. We offer reconciled books available 24/7, tax-saving insights, and a single place for all your financial data.
*The information provided on this website does not, and is not intended to, constitute legal advice. All information, content, and materials available on this site are for general informational purposes only. Readers are advised to consult with their attorney or accountant with any questions or concerns.*
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