This one may be the most important topic for you to understand out of the 50 topics.
Seller’s Discretionary Earnings (SDE) is a key metric used to calculate the true earnings power of a small or mid-sized business.
As stated in an earlier topic, the main thing a buyer wants to ascertain is “what will the business be worth the day after they buy it”. To make that ascertainment, certain adjustments need to be made.
NOTE – these adjustments should only be a spreadsheet exercise. The historical accounting system records and the filed tax return records should NEVER be modified.
What adjustments qualify as SDE adjustments
- Owner’s Personal Expenses
- Non-Recurring Expenses
- Redundant Expenses
It should be noted that there are several names for these types of adjustments:
- SDE Adjustments
- Addbacks – inaccurate inference because there can be additions and deductions
- Earnings Adjustments
They all do the same thing which is to reset the total earnings number for the entity. The exercise is to cleanse the current historical financials of costs and expenses that will not continue once the new owner takes over. In certain circumstances there can be revenue adjustments also.
There is often a lot of subjectivity in this process. Unrealistically opportunistic sellers (often guided by illicit brokers) will attempt to exploit this process beyond reason only to be completely exposed and denied by savvy experienced buyers.
This should be a legitimate fact-based process that leads to correctly normalized earnings.
Please note and adhere to the concept that full documentation will be required for all declared adjustments. The “oh I think it was about 20,000” type assertions will be immediately invalidated.
Let’s review the different types of adjustments.
Personal Expenses
Many businesses are what I call “tax managed”. This is where the seller and/or seller’s CPA conclude that the seller can either spend the money or “pay it out in taxes”.
I have never understood how completely wasting 10,000 to save 3,000 in taxes makes sense. It absolutely does not from a cash flow perspective.
Creative seller’s and CPAs come up with an unlimited list of personal expenses to “run through the company”. Everything from family cell phones, lavish trips, family members on payroll, expensive meals, expensive technology, home repairs, luxury cars, swimming pools, Disney time shares, helicopter rentals and on and on to more illicit better not listed here expenditures.
None of those have anything to do with the legitimate operation of the company so they all qualify as favorable SDE adjustments.
Non-Recurring Expenses
These expenses are usually much more factual and easy to value and define. Example 1 – storm severely damages the buildings roof and the seller has to pay 25,000 for the insurance deductible. Example 2 – the well runs dry and a new well with an anticipated 30-year life has to be dug. You can quickly see that neither of these expenses would be anticipated to recur in future years. Other types would include one-time professional fees, severance packages, reorganization charges, inventory write-offs and failed acquisition expenses.
Redundant Expenses
These are expenses that a prudent business operator would not spend.
Example 1 – the seller is compensated at 450,000 per year whereas an independently hired CEO would be compensated at 300,000 per year. This is an example of a positive and a negative adjustment. The 450,000 would be added back and the 300,000 would be deducted to achieve a net 150,000 favorable adjustment.
Example 2 – Charitable Deductions – unless there is an “unofficial benefit such as securing external favors” there is typically no business value received for charitable donations. The recipients are completely subjectively determined by the sellers. Consequently, almost all charitable deductions are allowed as positive earnings adjustments.
Example 3 – the seller buys an 80,000 painting for the office and charges it to the company.
In an earlier topic, I stated that an offering is a negotiation from the first moment to the closing day.
SDE adjustments are a prime example. Even under the most legitimate calculation possible there will be a certain amount of subjectivity as to what qualifies and what does.
On the aggressive meter I strive for a mid-point positioning, with the client understanding that if we achieve 80% of those declared that should be considered a success.
My preference is for the net SDE adjustment impact to not be more than a 20% increase to historical earnings.
However, under unique circumstances I have experienced and closed a transaction where the adjustments were greater than 60%.
The buyers are fully versed in this process and are accepting as long as there is no tax evasion involved.
You do not need to suddenly change your expensing practices once you contemplate selling your company. In fact, abrupt changes actually make it more cumbersome and difficult than not stopping.
Example, you rent a standalone building that you use for a hobby. It has absolutely nothing to do with the company. It is 10,000 per month. It is a lot more effective to list a positive adjustment of 10,000 per month in each of the 36 monthly columns than it is to list it for the first 30 months and then have to explain why it is suddenly zero for the most current six months.
This process needs to be taken very seriously and accurately. Many non-financially oriented brokers gloss right over this stage. An astute financial M&A advisor will work collaboratively with your financial team to determine every possible dollar to list.
Impact – if you sell for 6X adjusted earnings it will cost you 600,000 of purchase price for each 100,000 that was missed. This should be the greatest incentive of all!