A Seller's Discretionary Earnings (SDE) Worksheet
SDE and Business Valuation Variations amongst Sellers, Buyers and Lenders. In the last issue (#9), we provided an example of A Seller’s Discretionary Earnings (SDE) Worksheet. In this issue we will discuss SDE and Business Valuation Variations amongst Sellers, Buyers and Lenders.
"Credit is a system whereby a person who can not pay gets another person who can not pay to guarantee that he can pay." Charles Dickens
SDE and Business Valuation Variations amongst Sellers, Buyers and Lenders. In the last issue, we provided a detailed 30-item normalization of Seller’s Discretionary Earnings (SDE) for Mr. Husband’s day care center.
In the example below, the seller’s calculation of SDE equaled $251,000, the buyer’s evaluation of SDE totaled $220,000 and the bank’s SDE evaluation totaled only $120,000.
Rather than repeat all the details of the 30 add-back items, below is a consolidated summary of the calculations:
Lenders are very conservative in evaluating discretionary add-backs to SDE
Mr. Husband has a huge problem. He has run so many discretionary and non-business/personal expenses through his business that he has significantly degraded the value of the business. When it comes to discretionary expenses as add-backs to SDE, lenders will not usually accept them. Buyers have the opportunity to perform due diligence, so he might be able to convince them that some discretionary expenses are justified as add-backs to SDE by producing receipts for their review. But lender’s underwriters are not interested in reviewing receipts to approve add-backs for discretionary expenses. It’s just not going to happen. Most lenders limit their SDE calculation to EBITDA plus owner’s salary and few other expenses. They will impute a salary expense to adjust for uncompensated spousal labor and they do want the cost of occupancy (rent) adjusted to fair market value. They may or may not accept the owner benefit from retirement contributions as a valid add-back. But that’s about it. Lenders are notoriously conservative and that definitely holds true in the financing of business acquisitions.
Because of discretionary expenses, the bank values the business at one-half its "true" value
In this example, the bank has valued the business at less than one-half the amount the seller feels his business is worth ($753,000 vs. $324,000). Mr. Husband has overpaid his daughters by $59,000 and has deducted another $72,000 of discretionary and personal expenses on the corporate tax return. His corporation’s tax savings (at an effective corporate rate of 25%) on $131,000 in discretionary expenses is about $33,000. But, that $33,000 in tax savings cost Mr. Husband $429,000 in business valuation (vs. the lender – $753,000 less $324,000)!
This business may not be successfully sold. If it is, Mr. Husband will have to finance a substantial portion of the acquisition price
In light of the circumstances, at what value can Mr. Husband sell his business? Well, that’s difficult to answer. Let’s assume the buyer in this example …
