Partial Year Expenses When Calculating Sde

PARTIAL YEAR EXPENSES WHEN CALCULATING SDE

Hello. The company my partner and I are looking at hired an employee in September of last year. In the income statement for 2019, her salary is rightfully only 25% of the go-forward cost of having her on staff in[redacted]Assuming that we want to keep the employee in her current position and at her current pay, how should we think about the valuation of the company? 

For example, let's assume her salary is $50,000 per year. Should we decrease the previous year's SDE by $37,500 to account for the fact that our realized SDE will actually be lower by that amount (assuming no other growth) in 2020? Does the same logic apply to other expenses that started mid-year and will be continuing expenses moving forward?

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searcher McGill University - 04/24/2020

Hi Ryan - yes, deduct 100% of her salary and yes, it applies to all expenses that started mid-year. You want to value this company based on the cash flow it is expected to generate going forward (the "run-rate"). Cash flow that won't be realized going forward has no value to you.

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professional Villanova University - 04/24/2020

Ryan, you'll want to normalize the earnings of the firm to determine run-rate SDE. So you'll want to do this for new expenses as well as expenses that may have ceased. I'd be happy to talk to you further about it if you'd like. I do financial due diligence / quality of earnings so I see this type of thing on a regular basis. My email is [redacted] Hope to speak with you. -Dave

searcher Columbia University - Columbia Business School Boston College University College Dublin - 04/24/2020

I think this is more dependent on the type of expense - if the employee is a sales person then you could deduct it but you're not giving any credit for the potential revenue that person should generate or the revenue they already have generated it (if you don't runrate). If it's purely a new person to meet capacity needs probably makes sense to run rate.

searcher Massachusetts Institute of Technology - MIT Sloan School of Management Massachusetts Institute of Technology - 04/07/2021

Put another way, I’d use Bruce Greenwald/Warren Buffett’s logic of “growth CAPEX” vs “maintenance CAPEX” (I know these are operational expenses, but the logic’s the same). If this person is required to maintain existing revenues, like if they were replacing another employee, definitely include the expense as-if the employee was there for a year (assuming the prior employee wasn’t working that year). But if the person is there to grow sales, and those sales won’t materialize until later, perhaps include just the partial year expense in SDE.

Now, if the situation is ambiguous, err on the side of conservatism and multiply the expense for a full-year. From a price negotiation perspective if you’re pricing based on a multiple of SDE and f it’s easy to persuade the seller that the employee is like “maintenance CAPEX”, you’ll get a lower price if you can include the expense at the full-year level.

searcher University of Colorado at Boulder - 04/26/2020

Kyle, David, and Joshua. Thank you very much for your thoughtful responses. Because this person is not directly revenue generating, I agree that we should be deducting the full salary amount.

intermediary Indiana University at Bloomington Indiana University, Bloomington/Indianapolis - Kelley School of Business - 04/27/2020

I will take a little of the opposite view for consideration. 1st you need to see if this person took the place of someone who left the company earlier in the year. 2nd Why was this person hired, was business increasing and more capacity was required? Is it still needed? 3rd I will give the owner some credit to keep business moving forward, too many business owners who are thinking about sell don't expand and make due with what they have. 4th The seller has eaten the expense of the recruitment and training costs for you. Just a different perspective, can't make a call without more information.

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searcher - 04/27/2020

Ryan - to answer your question, yes you will need to adjust SDE for any partial year expenses with the goal of coming to a true steady state SDE cash flow figure. The question to ask is what is the business generating today annually with the current sales base and expense base?

PARTIAL YEAR EXPENSES WHEN CALCULATING SDE

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