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?

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Reply by a searcher
from Columbia University in New York, USA

My take on Owner's salary--assuming he/she is actively involved in the business--is that it's an ongoing operating expense of the business. Someone has to perform those duties and get paid for it. Either the Seller, the Buyer or a 3rd party person will perform those activities and get paid. In my opinion it doesn't matter that the Seller is the one getting that salary. Thus, in my opinion, it should be subtracted from earnings to reduce EBITDA. As for SDE, I wouldn't accept an add-back for a normal, recurring operating expense--in other words, the expense is NOT discretionary and shouldn't be treated as such. One caveat however: to the extent that the Seller is receiving an above-market salary, then the excess salary above market IS discretionary and should be allowed as an add-back. I see that others in this thread disagree, but this is just my opinion--the HBR Guide suggests the same treatment--i.e. not permitting Seller's salary as an addback if he's actively working in the business.

Reply by an intermediary
from Clemson University in Raleigh, NC, USA

There is confusion on the accepted recasting treatment of seller comp and benefits. 100% of all salary, benefits and employer taxes are added back to determine SDE. If you are attempting to convert SDE to EBITDA; a fair market wage, benefits package and employer taxes are subtracted from SDE to determine Adjusted EBITDA.

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.

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