7 Ways Seller Discretionary Earnings Boost Practice Value

When preparing to sell your dental practice, understanding its true profitability is paramount to determining a fair asking price. While net income on a tax return tells part of the story, a more crucial metric for buyers and brokers is seller discretionary earnings (SDE). This figure provides a standardized view of financial performance by adding back owner-specific expenses to the net profit, revealing the total financial benefit available to a new owner.

In this guide, we'll explore seven essential methods for calculating SDE, helping you accurately assess your practice's value and prepare for a profitable transition. Let's dive in.

Method 1: How Are Seller Discretionary Earnings Calculated?

Before diving into valuation methods, we must first understand the fundamental formula for seller discretionary earnings (SDE). The calculation begins with your practice's net income or post-tax profit. From there, you "add back" specific expenses that benefit you as the owner but are not essential for day-to-day operations.

To identify these figures, we need to read the business tax forms to assess revenues and expenses.

The basic SDE formula is:
SDE = Net Profit + Owner's Salary + Discretionary Expenses + Non-Recurring Expenses + Non-Cash Expenses (Interest + Depreciation + Amortization)

This normalization process reveals the practice's true cash flow potential for a new owner. The core question SDE answers is: What is the total financial benefit this practice generated for its owner?

Common add-backs in a dental practice include:

• The owner's salary (e.g., $150,000).

• Personal expenses run through the business, like a $5,000 vehicle lease.

• Salaries for family members in non-essential roles.

• One-time, non-recurring costs, such as a $20,000 legal consultation.

New owners may not elect to make the same discretionary expenses as you, or may wish to take a different salary. We wish to communicate the business earnings before owner compensation to the future owner.

Keep meticulous records to justify every add-back. A defensible SDE calculation, often prepared with a professional broker, is the bedrock of a strong valuation and a smooth sales process.

Method 2: The Normalized Earnings Method

Beyond calculating a single year's SDE, the normalized earnings method creates a more stable and realistic view of your practice's financial performance. This approach involves analyzing seller discretionary earnings over multiple years (typically three to five) and adjusting for any unusual spikes or dips caused by external factors. The goal is to smooth out irregularities and present what the business would typically earn under normal operating conditions. Properly tracking your business expenses is foundational to identifying these anomalies; for further insights, consider this practical guide on tracking business expenses.

This multi-year perspective demonstrates financial consistency and stability to potential buyers.

Common normalization adjustments in a dental practice include:

• Smoothing out revenue from a large, one-time corporate contract.

• Adjusting for the financial impact of an extended office closure for renovations.

• Normalizing performance from years affected by major economic events.

When normalizing, you might give more weight to recent years if the practice shows a clear growth trend. Document every adjustment with clear reasoning to build a credible valuation that buyers will trust.

Method 3: Cash Flow Reconstruction Method

Beyond standard add-backs, the Cash Flow Reconstruction Method offers a granular view of a practice's financial health. This approach rebuilds the cash flow statement from the ground up, emphasizing actual cash generated rather than accounting profits. It provides a truer picture of the funds available to a new owner by scrutinizing cash receipts, cash expenses, and changes in working capital. This is a critical component of calculating seller discretionary earnings accurately.

This method is particularly useful for practices with significant financial fluctuations. For instance:

• A cosmetic practice with large patient receivables affecting cash timing.

• An orthodontic practice with seasonal revenue patterns.

• A growing practice requiring significant investment in new equipment (capital expenditures).

To learn more about the nuances of financial evaluation, see this guide on understanding cash flow. This detailed analysis helps potential buyers understand the real-world financial performance that supports the final valuation.

Analyze at least 12-24 months of cash flow patterns, separate operating cash from financing activities, and account for necessary capital expenditures to present a clear and defensible cash flow statement.

Method 4: Industry-Specific Adjustment Method

While the core formula is universal, the specific add-backs used in a seller discretionary earnings calculation often vary by industry. This method tailors the SDE normalization process to account for unique operational metrics and expense patterns common within a specific sector, such as dentistry. It ensures the final SDE figure aligns with industry-standard practices and what an informed buyer expects to see.

This specialized approach reveals the true, comparable profitability of your practice. It answers the question: How does this practice’s financial performance stack up against others in the dental industry?

Common industry-specific adjustments for a dental practice might include:

• Normalizing for unique insurance reimbursement timing or write-offs.

• Adding back discretionary lab fees that a new owner might source differently.

• Adjusting for non-recurring expenses like specialized CE courses or new equipment a buyer wouldn't incur.

• Separating associate dentist compensation that functions more like a profit share than a standard salary.

Partner with a broker specializing in dental practices. Their industry expertise is invaluable for identifying legitimate, sector-specific add-backs that accurately reflect your practice's earning power and strengthen your dental practice valuation.

Method 5: Quality of Earnings Approach

Beyond the raw numbers, a sophisticated buyer will analyze the quality and sustainability of your earnings. This Quality of Earnings (QoE) approach dissects your seller discretionary earnings to understand its stability and predictability. It moves past "how much" the practice earns and asks "how reliable" those earnings are for a future owner. A QoE analysis gives potential buyers deeper confidence in your financial story.

This method evaluates the components of your revenue to present a more nuanced view of performance. For a dental practice, this could mean distinguishing between stable, recurring hygiene appointments versus high-value, one-time cosmetic procedures. The goal is to prove that your cash flow is not reliant on non-repeatable events.

Key areas a QoE report might analyze in a dental setting include:

• Patient concentration and new patient flow.

• Payer mix stability (e.g., PPO, FFS, Medicaid).

• Recurring revenue from hygiene vs. one-off specialist procedures.

• Trends in production per provider.

A formal QoE report, often prepared by a CPA firm, can significantly strengthen your position during negotiations. It demonstrates transparency and substantiates the long-term health of your practice’s cash flow, which is a core component of comprehensive dental practice valuations.

Method 6: Multiple Time Period Weighted Method

A standard seller discretionary earnings calculation often uses the trailing twelve months (TTM), but this can be misleading for practices with significant growth, decline, or seasonality. The multiple time period weighted method provides a more nuanced view by assigning different weights to various periods, offering a balanced perspective that reflects business trends more accurately. This approach helps create a justifiable SDE that considers historical context while emphasizing recent performance.

This method is crucial for demonstrating the practice's true earning potential. By adjusting the weight, you can highlight a strong growth trajectory or normalize a temporary downturn, leading to a more accurate valuation.

Practical applications include:

• Growing Practice: Weight the last 12 months at 60%, the prior year at 30%, and the year before at 10% to emphasize recent growth.

• Declining Practice: Use a more even weighting (e.g., 40/30/30) to avoid over-penalizing for a recent dip and present a longer-term average.

• Seasonal Practice: Employ a 24- or 36-month weighted average to smooth out predictable fluctuations and show a stable annual SDE.

Clearly document the rationale behind your chosen weights. This transparency is key when presenting your SDE and the resulting practice valuation to potential buyers, as it builds credibility and justifies the sale price.

Method 7: Pro Forma SDE Method

While traditional SDE looks backward, the pro forma SDE method takes a forward-looking approach. This calculation projects what a buyer could earn by implementing specific, planned operational improvements after the acquisition. It’s not based on historical performance alone but on the business’s demonstrable future potential.

This method helps a buyer visualize the return on their investment by answering the question: What could theseller discretionary earningsbe under new, optimized management? A pro forma SDE must be built on credible, documented strategies for growth and cost savings.

Common pro forma adjustments include:

• Projecting cost savings from professionalizing a family-run operation.

• Showing increased revenue from implementing a new digital marketing strategy.

• Demonstrating efficiency gains from planned equipment upgrades or new software.

Your pro forma projections must be conservative and backed by detailed analysis. Engaging industry experts to validate your assumptions can add significant credibility and help a buyer see the clear path to maximizing profit in your practice sale.

Seller Discretionary Earnings: 7 Method Comparison

From SDE to Sale Price: Valuing Your Practice

Mastering the calculation of seller discretionary earnings is far more than an academic exercise in accounting; it's the fundamental language of practice valuation. Throughout this guide, we’ve explored various methods, from the standard add-back approach to pro forma projections, all designed to paint an accurate and compelling financial picture of your dental practice. Understanding these methodologies allows you to tell the true story of your practice's profitability, showcasing its full potential to a prospective buyer.

How are earnings used to compute a practice valuation?

Once a stable SDE figure is calculated, a valuation professional applies a "multiple" to it to arrive at an estimated business value. For example, if your practice's SDE is $300,000 and the industry standard multiple for a practice of your size and type is 2.5x, the valuation would be $750,000 ($300,000 x 2.5). This multiple is determined by market conditions, practice location, growth trends, and risk factors.

Does the sale price of a practice equal its earnings?

No, the sale price of a practice is rarely equal to its SDE. As shown above, the SDE is a foundational component of the valuation, but the final sale price is typically a multiple of those earnings. Buyers are purchasing the future cash flow, so they pay a price that reflects the potential return on their investment over several years. For example, a buyer might pay $750,000 for a practice that generates $300,000 in SDE. While the sale price is not equal to the earnings, it is directly derived from them.

Remember, the goal is to present a transparent, defensible SDE figure that a new owner can realistically achieve. By diligently tracking and optimizing the components of your seller discretionary earnings, you are not just managing day-to-day finances; you are actively building long-term value and positioning yourself for a successful and lucrative transition.