For most small and very businesses in Amarillo, sellers discretionary earnings is an essential component to become familiar with. Sellers discretionary earnings is essentially the calculation of an owner’s cash flow. It incorporates all aspects of how an owner makes money. Sellers discretionary earnings is essentially earnings before interest taxes deprecation and amortization (EBITDA) plus all the owner’s discretionary expenses such as owner’s salary, the company payroll taxes on the owner’s salary, unearned salary to family members, expenses to the business that are personal benefits like the owner’s family health insurance, life insurance, personal auto expense, and so forth. Amarillo business owners calculating sellers discretionary earnings can be quite creative and have a long list of discretionary adjustments. 

A buyer looking to acquire a business in Amarillo needs to know all of the cash flow available from operations. When thinking of sellers discretionary earnings, it is essentially the total amount of pretax profits available to the owner. Unfortunately, sellers discretionary earnings is not a line item on the income statement. Therefore, it requires an Amarillo business owner to calculate it by making certain adjustments. An example of calculating sellers discretionary earnings for Amarillo businesses is shown below. I have also included a discussion of certain adjustments:

• Owner’s Salary. The owner can determine his or her own salary. Often the amount of salary versus profit is based on tax considerations, not the economic value of the work performed by the owner.
• Health Insurance. For the owners and the owner’s family. A direct benefit.
• 401K, pension, profit sharing, and so forth for the owner.
• Auto expenses. The automobile use of the owner and family. 

Anything on the add-back chart shown above and more may be personal benefits to the Amarillo business owner when calculating sellers discretionary earnings. Be aware this can be garbage in, garbage out. Some Amarillo business owners and valuators stretch personal benefits beyond what a second analyst might view as reasonable. A little variance between analyst views is normal, but credibility is lost when add-backs are not tenable. 

Sellers discretionary earnings adjustments for Amarillo businesses are adjustments for expenditures by the company made at the discretion of the owner. The owner chooses the expense, and usually, it is for the owner’s benefit. Other than just knowing what the SDE amount is, it is important to understand that business appraisals use sellers discretionary earnings as a method to value an Amarillo business.

Owners can pay themselves whatever they choose within the bounds of the Internal Revenue Service rulings. But the economic value of their labor can be estimated. The economic value is what reasonable third parties would pay to have the services performed. In many instances, valuators need to estimate the economic value of the work and separate it from profit distributions.

When estimating sellers discretionary earnings from the income statement and supporting documents, the salary of one owner is included. In most instances, this means that it is “added back” and not expensed for this calculation, in effect, the single owner salary is part of this particular cash flow. The theory is most small owner-operated Amarillo businesses have one owner, so that is the standard.

In situations with multiple owner-operators, the economic value of additional owners is estimated, and any excess value or profit is added back. For instance, XYZ Corp. has two owners. Bob owns 60% and takes a salary of $125,000. He works full-time and is doing high-level project management/owner work. His co-owner Sara owns 40%. Sarah is paid $75,000 for which she keeps the books 8 hours a week and has another job for the other four days a week. Her economic value to the business may be estimated as follows:

• 8 hours x $35/hour for internal bookkeeper = $280/week
• $280/week x 52 = $14,560.
• $75,000 salary – $15,000 economic value = $60,000

Therefore, in the above example, $60,000 should be deducted from expenses and added to the operating income to calculate sellers discretionary earnings. This adjustment will increase the estimated profit and sellers’ discretionary earnings for the Amarillo company. In many small businesses, the second owner may be underpaid. Frequently it will come out that a spouse works almost full-time for a nominal sum or no payment at all. This, too, should be adjusted, which may result in lower profits and sellers discretionary earnings.