In small business sales, it’s easy to get overwhelmed with all of the jargon and acronyms. It seems like everywhere you look and everyone you speak to has a different name for the same thing. So we wanted to clear up one of the confusing terms by explaining it in detail and stressing its importance to a business sale transaction.
"Discretionary Earnings (DE)" is the same thing as “Seller’s Discretionary Earnings (SDE)” is the same thing as “Owner Benefit.” You might see it referred to as “Cash Flow” on www.BizBuySell.com or “Adjusted Net” on business MLS listings. Basically, they are all different ways of referring to the same number. This is the amount of money that the new owner should expect to get from the business, after the business’ expenses are paid. Let’s explore this concept a little deeper.
What Exactly is DE (Discretionary Earnings)?
DE or SDE or Owner Benefit or Cash Flow or Adjusted Net is the amount of money that the business earned in profit (in a given year), after essential business expenses. It’s the business owner’s decision as to what they would like to do with it. They might pay themselves a big salary out of it, they might invest it back into the business, or they might just leave it in the business’s bank account. This is the amount of money that a new buyer should expect to earn with the business if they run it in a similar manner to the previous owner. Three years of DE is normally calculated when valuing a business. 3 years of DE numbers are also presented to potential buyers, in order to demonstrate how the business has been performing historically. Normally, on advertisements of business listings, you will see the most recent year’s DE displayed.
Typically, the owner’s salary is left in this number (and not counted as a business expense), as every owner has the right to choose what they want to pay themselves. So, when potential buyers are looking at the DE on different business listings, they need to look at the number and make sure it has more than enough in it to pay themselves their desired annual salary. In order to calculate an accurate DE number, a business broker will perform what’s known as a financial recast.
Financial Recasts
It’s no secret that small businesses are notorious for running as many personal expenses through their business as they possibly can. That’s a big unofficial benefit of being a small business owner. Many of the businesses that we sell do it. The goal is to limit the amount of profit that is shown on their tax returns, for obvious reasons.
Because the reported profit on business financials aren’t always showing the true picture of what a new owner would be getting, business brokers need to perform a financial recast. A recast is the normalization of the business’s expenses. With the seller’s help and guidance, a business broker will be completing “add-backs” of certain expenses that are non-cash deductibles, personal expenses, and non-essential business expenses. A normalization of the finances is going to highlight what the actual owner benefit or discretionary earnings will be. A buyer needs to be able to see what the bottom line to them really is, and then they are going to verify that those numbers are correct during their due diligence period. So, it’s really important to get the recast done correctly in the beginning, so there are no surprises down the line.
Of course, having clean financials with minimal add-backs and showing more profit on the business’s tax returns is a much more straight-forward purchase, but that is not always the reality of what we are working with in small business sales.
Why is DE Important?
Getting to the true owner benefit that a business generates will directly relate to the value of the business. So, that’s why doing the financial recast is the first step in the valuation process, so we know exactly how much in DE that we are working with. Once we have a DE number that we are confident is accurate, then we can move on to the next step of analyzing comparable sales and industry multiples, in order to find the most likely selling price of the business.
If the DE calculation is wrong, then the price of the business will most likely be off too, since the two are connected. So, it is important to make sure the DE advertised is as accurate as possible. That way buyers will be able to clearly see what they should expect to earn, should they purchase the business and operate it in the same manner as the previous owner.