Seller’s Discretionary Earnings is a very important concept to understand

Because it is the foundation of business valuation for small businesses, Seller’s Discretionary Earnings (SDE) is an important concept to understand.  Having an SDE below $100,000 is a major obstacle to a successful sale of a business (but not impossible).  (Read Issue #57 – Inadequate Seller’s Discretionary Earnings.Other obstacles that contribute to inadequate SDE and have future newsletter articles devoted to the topic include: Issue #58 – Low or Inconsistent Gross Margins, Issue #59 – Inadequate Sales and Marketing and Issue #72 – Excessive Personal Expenses and Skimming Cash.

Small business valuations are based on multiples of Seller’s Discretionary Earnings

When it comes to valuing a small business (under $3,000,000 in value), SDE is the common denominator to which a multiple is then applied.

The multiples are driven by a range of financial factors including: 1) financing formulas; 2) the buyer’s need to have a reasonable return on investment after paying debt service on the acquisition; and 3) the buyer’s need to receive reasonable compensation for the time and effort required to run the newly acquired business.  There are numerous other factors, including the industry, that can also affect the selection of an appropriate multiple.

But one of the primary factors is the level of SDE itself.  For financial reasons, buyers are willing to pay a higher multiple for higher SDE.  The following is representative of the range of multiples at various “cash flow” (SDE) levels:

SDE    MultipleBusiness Value
$50,0001.0 – 1.25$50,000 – $62,500
$75,0001.1 – 1.8$82,500 – $135,000
$100,0002.0 – 2.7$200,000 – $270,000
$200,0002.5 – 3.0$500,000 – $600,000
$500,0003.0 – 4.0$1,500,000 – $2,000,000
$1,000,000       3.25 – 4.25       $3,250,000 – $4,250,000