NON-BUSINESS EXPENSES TO RECAST WHEN DETERMINING SELLER'S DISCRETIONARY EARNINGS

Introduction:

In the lower middle market business, determining the Seller's Discretionary Earnings (SDE) is crucial for evaluating the true profitability and value of the business. SDE represents the total cash flow available to the owner, including both business and personal expenses. While business expenses are relatively straightforward to identify, it is important to recast non-business expenses accurately to present a comprehensive financial picture. Here are key non-business expenses that should be considered when calculating SDE:

1-    Owner's Salary:

Include the owner's salary as part of the business expenses. Often, small business owners pay themselves irregularly or take a lower salary than what they would receive in a similar position in another company. Adjusting the owner's salary to a reasonable market rate ensures a more accurate representation of the business's financial health.

2-    Personal Expenses:

Identify personal expenses that are currently being paid by the business. This can include items like personal travel, entertainment, subscriptions, or memberships that have been attributed to the business accounts. Recast these expenses as personal expenses and exclude them from the SDE calculation.

3-    Discretionary Benefits:

Consider discretionary benefits provided to the owner or their family members, such as personal vehicles, health insurance premiums, life insurance policies, or other personal perks paid for by the business. These benefits should be recast as personal expenses and excluded from SDE to reflect the true cash flow available to the buyer.

4-    Non-Recurring Expenses:

Exclude one-time or non-recurring expenses that are unlikely to repeat in future years. These can include legal fees related to a specific event, significant repairs or renovations, or expenses associated with a non-recurring marketing campaign. By excluding these expenses, the SDE calculation provides a more normalized view of the business's ongoing profitability.

5-    Excessive or Non-Essential Costs:

Evaluate the business for any excessive or non-essential costs that do not contribute significantly to the core operations or profitability. These expenses can include extravagant office rent, luxury company vehicles, excessive entertainment or travel expenses, or high-cost vendor contracts. Recasting or reducing such expenses to more reasonable levels allows for a more accurate SDE calculation.

6-    Non-Business Assets:

Exclude any income or expenses related to non-business assets that are co-mingled with the business finances. For example, if the business owns rental properties or investments, the rental income and associated expenses should be treated separately from the SDE calculation.

7-    Related Party Transactions:

Identify any transactions or expenses involving related parties, such as family members or close associates. Ensure that these transactions are conducted at arm's length and adjust the expenses to reflect fair market value. This step helps avoid artificially inflating or deflating the SDE by manipulating transactions with related parties.

Conclusion:

Determining the Seller's Discretionary Earnings (SDE) in a lower middle market business requires careful consideration of non-business expenses. Accurately recasting these expenses allows potential buyers to assess the business's true profitability and make informed decisions. By incorporating these key points into the SDE calculation, both buyers and sellers can navigate the transaction process with transparency and confidence. For access to professional services nationwide to assess the value of your business in the US and Canada, simply CLICK on the button below.