Seller Discretionary Earnings referred to as SDE equals net profit, which is the sum of annual revenue minus expenses, plus add-backs of seller discretionary spending.
SDE directly impacts enterprise value, buyers equity injection, loan amount, seller carry amount, and debt service coverage ratio which ultimately determines whether a loan application is approved or declined.
Common expenses added back by sellers beyond Interest, Tax, Depreciation and Amortization include officer salary and benefits, meals and entertainment, travel, automobile loan payments, cell phone and internet bills and personal care items.
I’ve also witnessed seller discretionary add-backs of child care, alimony, child support and a whole host of other questionable expenses. I don’t recommend business owners expense these items if their exit strategy is to earn maximum enterprise value in an arms length sale transaction.
Sellers are incentivized to add back expenses, even questionable one’s, primarily to inflate the businesses enterprise value.
Sellers feel justified adding these expenses back due to their years of blood sweat and tears starting and operating the business and also because they are convinced these expenses are unique to them and are indeed discretionary.
On one hand, sellers are correct, as the word discretionary means available for use at the discretion or choosing of the user.
However, lenders literally review hundreds of profit and loss statements each year with nearly all of them including most, if not all, of these aforementioned expenses.
Therefore, though these expenses may be discretionary they are also so common most lenders expect buyers to also expense these items thereby nullifying their discretionary nature.
Sellers should expect that in almost every case meals and entertainment, travel, automobile loan payments, cell phone and internet bills and personal care items will not be added back by lenders.
Proceeding with the loan application without accurately assessing SDE may set up a scenario where the loan is conditionally approved but the business valuation derived is less than the sale price.
If this happens, In almost every case there are three possible outcomes: The applicant is required to inject more equity, The seller is required to carry a larger loan amount or the loan application is declined.
That’s why it’s important to structure the loan for success, in compliance with all SBA policies and procedures prior to submitting the loan application.
On the other hand, officer salary and benefits are generally accepted add-backs to a point, which makes sense, as the seller will no longer be monetarily compensated by the business.
The point the sellers salary and benefits will not be added back is directly related to the buyers cost of living.
For example, if a seller is compensated by the business in the amount of $200,000 and the buyer requires compensation of $150,000 to pay for personal debt and living expenses then only $50,000 can justifiably be added back to service the SBA 7(a) loan used to purchase business.
There is a unique scenario when meals and entertainment, travel, automobile loan payments, cell phone and internet bills and personal care items may be added back by the lender.
This unique scenario is when the applicant owns another business which already expenses these items and there is therefore now no need to expense these items through the acquisition target.
In this scenario an existing business owner has an advantage over a W2 employee who will leave their employer after the acquisition is completed and is generally expected to expense these items on the advice of their tax advisor.
One last thought and recommendation for business owners preparing their business for sale.
Be extra careful to hire a business broker who understands how lenders allocate seller discretionary expenses to ensure the businesses purchase price is aligned with the buyer’s ability to qualify for financing. If you need one, I’m happy to make an introduction to a respected business broker in your area.