Here’s Why SDEs and Add-Backs are More Important Than You Think

If you’re thinking about jumping into the world of acquisition entrepreneurship, making sure you pay just the right amount for a business is an absolutely critical task. 

One way to get it just right is to thoroughly understand add-backs and Seller’s Discretionary Earnings (SDE) – two financial concepts that are often confused but can have a big impact on valuation.

Add-backs help identify expenses that won’t apply to you as the new owner, ensuring you’re not overpaying for the business based on its true earning potential

Acquira had the opportunity to sit down with Brittany Green, a certified valuation analyst with Green Appraisal, to learn more about the realities of SDE and add-backs.

SDE vs Add-backs

Both terms are crucial when evaluating the financial health and value of a small to medium-sized business, especially in the context of a sale or acquisition, says Brittany. However, they often lead to confusion due to their nuanced differences. 

“There’s a considerable difference between the two,” she says.

Seller’s Discretionary Earnings (SDE) is essentially the total financial benefit one individual owner-operator would derive from a business in a single year. 

It represents the pre-tax earnings of the business before deducting owner compensation, interest, taxes, depreciation, and amortization but after adding back certain discretionary, non-operating, or non-recurring expenses.

These might include the owner’s salary, personal expenses run through the business, one-time costs, or other discretionary expenses.

Add-backs are specific expenses that are added back to the business’s profits to more accurately represent its financial performance. 

These are adjustments made to the reported profit to reflect the true economic benefit to the owner. 

Common Add-Backs

Common add-backs include the owner’s salary above market rate, personal expenses disguised as business expenses, depreciation, and interest expenses. 

They can include:

1. Personal Expenses: Such as personal travel, entertainment (e.g., buying Taylor Swift tickets through the company), and personal vehicle expenses (insurance, inspections, smog tests).
2. Non-Recurring Expenses: Costs associated with specific events like relocation or legal disputes and the launch of new product lines. Brittany says she has worked on a valuation for a medical device company that frequently launches new products, as an example with a lot of non-recurring expenses.
3. Excessive Perks or Benefits: Luxuries such as club memberships or extravagant meals. Brittany says she valued a survey company where country club memberships were used to entertain vendors and customers, which would be considered a personal expense.

“So essentially, the way that we can look at this is that add-backs add up to your seller’s discretionary earnings, which is why they sometimes get interchanged and misused,” says Brittany.

The goal here is to present a clearer picture of the company’s operating performance and its potential profitability to a new owner, says Brittany.

“We want a clearer picture of the business’s earning potential,” she says. 

Add-backs help identify expenses that won’t apply to you as the new owner, ensuring you’re not overpaying for the business based on its true earning potential.

Why Does this Matter when Buying a Business?

Brittany says the amount that is included in the add-backs can dramatically change how much a business is valued at – and, accordingly, how much you’ll have to pay for it. 

Let’s look at an example that illustrates the impact of add-backs and SDE in a business valuation scenario, especially when dealing with two owners, each drawing a salary of $150,000. 

To make this example clear and relatable, we’ll consider a business with a basic profit and loss statement before diving into the valuation nuances.

Initial Business Financials:

• Net Profit (Before Owners’ Salaries): $500,000
• Owners’ Salaries (Total for Two Owners): $300,000 ($150,000 each)
• Other Discretionary Expenses: $50,000

In this scenario, to calculate the SDE, we start with the net profit and add back any expenses that wouldn’t necessarily apply to a new owner. These include the owners’ salaries and other discretionary expenses.

Calculation without Add-backs

If we don’t add back the owners’ salaries or other discretionary expenses, the business’s attractiveness from a profit standpoint appears limited to the net profit of $500,000. 

This figure does not accurately represent the business’s earning potential for a new owner, as it doesn’t account for the substantial salaries drawn by the current owners.

Calculation with Add-backs (Incorporating SDE)

1. Net Profit: $500,000
2. Add-back Owners’ Salaries: $300,000
3. Add-back Other Discretionary Expenses: $50,000
4. SDE: $500,000 + $300,000 + $50,000 = $850,000

With the add-backs, the SDE is $850,000, significantly higher than the initial net profit. This figure more accurately reflects the total economic benefit available to a new owner since it includes the salaries and discretionary expenses that could be adjusted post-acquisition.

Impact on Valuation

When you’re looking to buy the business, the valuation significantly hinges on the SDE rather than just the net profit. Businesses are often valued at a multiple of their SDE, ranging from 2x to 6x or more, depending on the industry, market demand, and other factors.

• Valuation without Add-backs: If we naively used just the net profit, the business might be undervalued. For example, using a simple 3x multiple of the net profit ($500,000), the valuation would be $1.5 million.
• Valuation with SDE Add-backs: Using the SDE of $850,000 with the same 3x multiple, the valuation would increase to $2.55 million.

Another thing to keep in mind when dealing with add-backs and SDE is asking yourself who is going to cover the work done by the two owners once you buy the business. 

“Consider how you’re going to have to operate the business and take those things into consideration,” she says. 

Adding back their salary increases the valuation, but you’ll either have to pay someone to cover their workload(thereby reducing SDE) or do the work of two people. 

“So the thing to take away is that just because the CIM or their prospectus or whatever paper they give you that says, ’Hey, we got to add all of this back,’ that may be true for their personal expenses, but consider how you’re going to have to operate the business and take those things into consideration.”

Settling on Add-backs while Negotiating with a Seller

Brittany says that sellers will often try to include a variety of questionable add-backs – perhaps they are claiming that there are staff redundancies or seemingly one-time marketing expenses. 

To take the latter, it really depends on how much a similar company would spend on marketing. If it’s within a similar range, that is likely not an add-back, even if it’s a one-off. 

“It might not necessarily be an add back, but we don’t know until we look at what the industry averages tell us,” she says. 

As far as staffing cuts go, they likely aren’t legitimate add-backs. 

“You know, if it’s so easy, why didn’t the seller do it before selling? You know, it sounds like he’s just trying to add things back in to boost his value,” she says. 

This becomes important when going to a bank to get a loan to purchase the business because they might exclude some of these add-backs anyway. 

“The bank may not take add-back A but they may take add-back B that they see that the seller never even took into consideration,” Jennifer says. “So, a lot of the time, it doesn’t end up balancing out.”

Conclusion

Navigating the complexities of SDE and add-backs is crucial for accurately determining a business’s worth. 

Whether it’s adjusting for personal expenses, considering non-recurring costs, or evaluating the implications of excessive perks, understanding these concepts is essential for buyers and sellers alike.

By taking into account industry standards, potential staffing changes, and bank perspectives on add-backs, stakeholders can ensure a fair and transparent valuation process. 

If you are thinking about buying a business and want to learn more about SDE and add-backs, reach out to Acquira to learn more about our Accelerator course – a super-charged, MBA-level training that could see you at the helm of a seven-figure, cash-flowing business in as little as seven months. 

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Key Takeaways

• SDE represents the total financial benefit to an owner-operator.
• Add-backs adjust profits for a true economic benefit depiction.
• Understanding these concepts prevents overpaying for a business.
• Critical for buyers to assess the operational impacts of add-backs.
• Negotiating with sellers requires knowledge of legitimate add-backs.

Team Acquira

Acquira specializes in seamless business succession and acquisition. We guide entrepreneurs in acquiring businesses and investing in their growth and success. Our focus is on creating a lasting, positive impact for owners, employees, and the community through each transition.