Seller Discretionary Earnings And Add-Backs: What Lenders Accept

What Seller Discretionary Earnings Means

Seller discretionary earnings, or SDE, answers one question: if one owner ran this business full time, how much cash would it produce for them before any acquisition debt?

It starts with the net income on the tax return and adds back costs that a new owner would not have, or that are not really operating costs:

• The owner's salary and payroll taxes, because the new owner's pay replaces it
• The owner's benefits, such as health insurance paid by the business
• Interest, because the seller's debt is paid off at closing
• Depreciation and amortization, which are accounting entries, not cash spent this year
• One-time expenses that will not happen again
• Personal expenses run through the business

Brokers use SDE because most small businesses are bought by an owner-operator, and SDE shows what that person can expect. It is the figure behind most asking prices. To see how it turns into a price, read how to value a business.

SDE Vs EBITDA

EBITDA is earnings before interest, taxes, depreciation and amortization. The key difference from SDE: EBITDA keeps a market salary for whoever runs the business as an expense. SDE adds the owner's pay back.

For SBA cash flow testing, lenders work closer to EBITDA. SBA defines historical debt service coverage as EBITDA divided by the combined debt payments after the purchase. Your pay as the new owner has to come out of the cash flow before the lender measures what is left for debt.

How SBA Lenders Treat Add-Backs

SBA gives lenders room to adjust the seller's numbers, with strict conditions:

• Every add-back must be justified. The lender has to explain in its credit memo why each adjustment is prudent, necessary and supported by the ongoing operations of the business.
• Unsupported add-backs do not count. Adjustments without the lender's supporting analysis are ineligible for the cash flow test.
• The owner must be paid enough to live on. Your compensation as the new owner must cover your current obligations and living expenses.
• Changing owner pay needs a global check. If the lender adjusts owner compensation, it must run a global cash flow analysis showing you can still meet your obligations, at a minimum of 1 to 1.
• The numbers must be verified. The lender checks the seller's tax returns against IRS transcripts.

SBA also lists the kinds of items lenders must think through when adjusting cash flow, including unfunded capital expenditures, non-recurring income, distributions, distributions for S corporation taxes, seller discretionary expenses and owner compensation. Some of those are additions. Some, like unfunded capital spending and one-time income, are subtractions.

Add-Backs That Usually Hold Up And Those That Do Not

In our experience, here is how lenders typically see common add-backs:

SBA does allow prudent adjustments for savings that the transaction itself creates, like a cost that disappears because of the new ownership structure. Projections, on the other hand, can be evaluated but cannot be relied on to meet the cash flow requirement.

A Worked Example

Here is how a seller's SDE is built, and how a lender turns it into a cash flow figure for the loan.

The seller's broker listed this practice at $574,000 of SDE. The verified figure is $474,000. That $100,000 difference matters twice: once in the price, if it is based on a multiple of SDE, and again in how much debt the cash flow can carry. That is why you should rebuild SDE from the tax returns yourself before you make an offer. See DSCR for a business acquisition for the next step.

What A Quality Of Earnings Report Adds

When the Business Purchase Price is $3,000,000 or more, SBA requires a Quality of Earnings report on top of the valuation. On add-backs, it goes much deeper than a lender's own review:

• It must identify and document every add-back and adjustment, including non-recurring items, above- or below-market owner pay, related-party transactions, deferred maintenance and differences between cash and accrual accounting.
• It must include a Cash Proof, reconciling bank statements to the income statement and tax returns, for the trailing 12 months and the last two fiscal years.
• It must assess revenue quality, including customer concentration and whether revenue and margins will hold after the sale.
• The lender must use the QoE earnings for the cash flow test. If they do not support the price and debt, the loan is reduced, and more equity can fill the gap.

The QoE must be independent and for the lender's benefit, not prepared by or for the seller. More in the Quality of Earnings report guide.

How To Review Add-Backs Before You Make An Offer

• Get three years of business tax returns and the current year-to-date financials
• Rebuild SDE yourself, starting from the tax return net income
• Ask for support behind every add-back: invoices, payroll records, statements
• Ask whether any "one-time" expense happened in more than one year
• Subtract a salary you could actually live on as the new owner
• Divide what is left by 1.25 to see the most annual debt payments it can carry
• Watch for interim results that are weaker than the last full year

Treat any add-back you cannot document as zero. If the deal still works, you have a solid deal. This article is general information, not tax or accounting advice; have a CPA review the seller's financials.

When you have a target, send us the CIM and the returns. We will review the add-backs the way lenders do and tell you whether the deal fits before you sign a letter of intent. Get a pre-qualification letter to show sellers you can close, and see how the loan works on our SBA business acquisition loan page.