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If your goal is to sell your e-commerce business someday, many factors will determine how much buyer interest you will receive, not to mention your business’s ultimate sale price. These factors include the quality of your products and listings, your systems, team, and intellectual property, SKU diversity, number of competitors, compliance concerns – the list goes on and on.
But the most important factor is Seller’s Discretionary Earnings (SDE). Sometimes referred to as Adjusted Cash Flow (or Adjusted EBITDA), SDE is a profitability measurement that shows the amount of cash the business generates that can either be distributed to the owner or reinvested in the business. More important than net profit, SDE is your business’s core profitability number. Check out the video below for more information from our Valuation Series.
It is vital to know and understand your SDE because buyers will require you to show these numbers.
If you’re not looking to exit any time soon:
Knowing your SDE will allow you to see a true picture of your business’s financials, cut the fluff, and run a lean and mean operation that maximizes your profitability.
Understanding Seller’s Discretionary Earnings (SDE)
The standard e-commerce term for adjusted profit, SDE allows you to view your profitability through a buyer’s lens. It attempts to normalize the performance of different businesses (since no two are alike), so that the buyer can make better decisions about how much a business is worth.
Take these two $1-million sellers who run their businesses very differently. Guy A is a solopreneur who does all of the work and prefers to use a manual spreadsheet over SaaS products to track his business. Gal B has a day job and therefore has hired a manager to run her Amazon shop. She likes to go to Amazon conferences for networking and she uses lots of SaaS tools and contractors.
Their operating expenses will look very different, but how profitable is the actual core of the business? If I were to buy Guy A’s business and don’t plan to be a one-man shop, I will likely make less profit than his books are showing because I’m going to need some additional help. If I were to buy Gal B’s business, I likely won’t need to spend nearly as much money and could likely make more money because this will be my full-time job.
If I buy one of these businesses, I’ll want to know my chances at profitability. That’s where calculating SDE comes in.
How is SDE calculated?
There are two ways to calculate SDE:
- Net Income plus any expenses that are considered “add backs” (expenses the new owner likely won’t have to spend this money on on an ongoing basis); or
- Gross Profit minus any expenses that will be required to continue running the company to maintain its existing SDE. The most significant expenses that will carry over to the new owner are advertising and non-owner salaries or contractor wages.
What are examples of Add Backs?
Knowing what counts as an add back can be a gray area, but to figure them out, think of yourself as a buyer and then ask the following question about each expense: “In order to operate this business, will I have to continue paying this money?”
As a general rule, if it’s unknown whether a buyer would continue to have to pay this expense after they take over your business, you should count it against your SDE. In most cases the buyer will ask, “If you didn’t need that expense, why did you spend that money?” If you were testing new ideas or playing with new product blends, there’s a good chance that the new guy or gal will have to do the same.
What is my SDE multiplier?
Brokers and investors will value your company based on a multiple of your agreed-upon SDE. For retail arbitrage and wholesale sellers, the multiple is pretty low (1-2X). For brand owners, the multiple tends to be 2-4X depending on margins, growth speed, earnings consistency, and intellectual property matters.
Bigger deals also tend to get higher multiples. You are a much riskier target if you are a small company generating $250,000 per year in sales versus a company generating $10 million per year in sales. The $10 million guy probably has a much more stable company and has had to solve more problems in order to get to that size. The larger guy is more likely to get a 4X offer, while the small guy is more likely to land closer to 2X.
How much will a buyer pay for my business?
To sum it up, the basic formula for valuing an e-commerce seller’s business is:
Value = (SDE X Multiple) + Good Inventory
A quick note on good inventory:
Let’s talk about inventory that you already own when you sell. The good news is that your business is worth more if you have inventory ordered and ready to go – that way, the buyer can hit the ground running when he purchases you. The bad news is that you only get credit for sellable inventory. If you have inventory that is close to expiring or obsolete or isn’t moving, a buyer won’t pay more for that inventory.
The most important thing is to clear out bad inventory and have your inventory management system set up so that as much of your inventory as possible is “good inventory”.
How do I improve my SDE?
First, if you feel like you have expenses that don’t need to be in your business because you might lose the add-back argument, wipe them out. It is a lot easier to tell an investor, “Hey, I realized that I didn’t need that SaaS product back in June, I killed it and my sales are still the same. Therefore, I want to add back the months of that expense up to June.”
By comparison, if you are still using and relying on a tool, it will be harder to convince a buyer that they won’t need that tool if they buy your business.
Next, make sure that your books are clean enough that you clearly see which expenses are critical versus discretionary. (Wink wink – Seller Accountant can help.) Also make sure you understand which expenses are variable expenses versus fixed expenses.
Last but not least, the SDE formula is still useful even if your business isn’t on the market yet. Use this formula to maximize visibility into your profitability. Our team uses the Post-Advertising Gross Profit (PAG) metric when providing outsourced CFO services to our many e-commerce seller clients. Here’s where you can learn how to measure and manage Post-Advertising Gross.
Need help preparing your business to sell? Or to simply ensure that you are maximizing your business’s profitability? Contact Seller Accountant for a free consultation!