With two little boys think to a couple of years time when they are out in the yard playing football etc. We have a big backyard and I am glad we didn't make it smaller while the girls were younger as it gave them plenty of space to play and be safe.

If the shed is so bad maybe get more light into it as red backs don't like a lot of light.

Just a thought: if you go ahead with the entertainment area why not build a storage area at the same time to keep things like BBQ and shed things and then get rid of the shed. It could have special glass doors for safety and for light & to keep it safer from spiders.

These are just my rambling thoughts.