SDE addbacks (Owner salaries)
June 11, 2024
by a searcher from The University of Chicago - Booth School of Business in Greenwich, CT, USA
Hi all,
Reaching out to tap into the wisdom of this community. How the owner salary should be treated for SDE calculation, when the owner is 100% involved in the deal?
In the last 30 days, 3 deals i looked at, had SDE calculations where the owner(s) salary was added back, although the owners are 100% involved in the business, but no market wages for equivalent positions were considered to replace those positions. All these were with business brokers (not that sophisticated in my opinion), and when I mentioned that's not the right way to calculate SDE, you need to consider market wages to replace those positions (even if smaller amounts), they become defensive.
What should I do, is it even worth mentioning this? Why would they do this? What am I missing here?
from Clemson University in Raleigh, NC, USA
This is why SDE multiples are typically 2x-3x and EBITDA multiples are typically 4x-6x. The profitability of the business determines which approach is appropriate. A rule of thumb I derived is that businesses with $750k-$1M of SDE should be valued using Adjusted EBITDA. If the business does not generate that or more should be valued using SDE.
It's worth noting that SDE=Seller Discretionary Earnings and by definition the amount the owner chooses to pay themselves is discretionary.
from University of Michigan in Bay City, MI, USA
The issue is that they SHOULD normalize to a market wage / salary for what the owner does. If he or she works 2 hours a week in the business doing a little bit of bookkeeping but draws a salary of $200,000 per year, then much of that should indeed be added back.
The more typical situation, though, is that the owner is working###-###-#### hours per week doing very high-level stuff and not drawing any wage on the books (or a very minor one to appease the IRS if they're taxed as an S-corp). In this case, SDE should actually be adjusted DOWNWARD to be accurate.
The bottom line is that one should not pay a multiple for a job that pays market wage. That is attainable without capital. Only free cash flow / EBIT / EBITDA should have a multiple applied.
This comes into play most directly on smaller deals. If there is $250k in claimed SDE, yet the owner is an experienced engineer working 60 hours a week to make the business go, how much cash flow is there really? Not a hell of a lot. Paying 3X of $250k is absurd, but that's what bad brokers are telling sellers to expect.
If we're going to play the game of including owner wages as part of SDE, then multiples need to be 1-2X max for small deals. The problem is, they want to calculate it one way but get the multiples of larger, EBITDA-based deals.
This crap is the bane of my acquisition existence.