Understanding Seller Discretionary Earnings

Buying a Software as a Service (SaaS) business can be an exhilarating venture. It can offer you the opportunity to acquire a company built around recurring revenue, scalable products, and a vast market scope. However, it’s crucial to fully comprehend how the company’s profitability is assessed. One of the key metrics often employed in the analysis of a SaaS business is Seller Discretionary Earnings (SDE).

In this article, we’ll dive into the world of SDE. We will discuss what it measures, how it came to be, and why many prefer it over other metrics, such as revenue.

Defining Seller Discretionary Earnings (SDE)

Seller Discretionary Earnings is an earnings metric used to reflect the total financial benefit that a single owner-operator would derive from a business on an annual basis. SDE is often used for small businesses, including many SaaS companies, especially when they’re sold by single owner-operators.

What SDE Measures

SDE aims to provide an accurate reflection of a business’s overall financial benefit. It does so by adding back non-cash expenses, one-time expenses, and discretionary expenses to the business’s net profit. This provides a more comprehensive view of the financial gain an owner-operator could expect.

The primary components of SDE include:

• Net Income: This is the profit after all costs, including taxes, operating expenses, interest, and depreciation, have been deducted from the total revenue.
• Owner’s Salary: In small businesses, the owner’s salary is usually a large expense and is added back into the SDE because it’s assumed the new owner will take over the operations.
• Non-Cash Expenses: These include depreciation and amortization, which are accounting deductions and do not involve actual cash outflow.
• One-time or Non-recurring Expenses: These costs, such as legal expenses for one-off situations, are added back because they won’t affect future operations.
• Discretionary Expenses: These are costs that aren’t necessary for business operations, such as travel or entertainment expenses.

The Genesis of SDE

The use of SDE as an assessment tool originated from the need to evaluate the true earning potential of small businesses, particularly those with a single owner-operator. These businesses often have significant expenses that are discretionary or one-off. A traditional measure like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) doesn’t add back these costs, making it unsuitable for small businesses where the owner’s decisions significantly impact the financials.

SDE came into use to provide a more realistic picture of a business’s profitability by considering the total owner benefit, not just raw profits. It offers a much clearer view of a small business’s earning potential and, therefore, is now widely used in small business and SaaS valuation.

The Advantage of SDE Over Revenue

While revenue is a valuable measure of a company’s size and market dominance, it doesn’t tell the whole story. Here are a few reasons why SDE is often favored over revenue:

1. Profitability Assessment: Revenue doesn’t account for expenses and doesn’t show how much of the revenue is actually translating into profit. SDE, however, gives a clearer idea of profitability as it reflects the total benefit to an owner-operator.

2. Owner’s Personal Benefits: In small businesses, many costs, such as the owner’s salary, aren’t indicative of the business’s operational performance but significantly impact profitability. SDE adds back these expenses, providing a clearer picture of financial gain.

3. Comparability: Businesses have different ways of structuring costs, which can make comparing revenues misleading. But because SDE adds back discretionary and non-cash expenses, it allows for more accurate comparisons between businesses.

In conclusion, when buying a SaaS company, it’s crucial to understand the company’s true earning potential and profitability. Seller Discretionary Earnings, with its focus on owner benefit and its comprehensive approach to profitability, provides a more realistic view of a small business’s financial health. It’s a valuable tool for investors looking to make well-informed, profitable investment decisions in the world of SaaS. Remember, it’s not just about the revenue a business generates, but about the profit that ends up in your pocket.