Key takeaways
- 01Seller's discretionary earnings is pretax profit plus one owner's compensation, interest, depreciation, amortization, and documented personal or nonrecurring expenses.
- 02Only one owner's compensation is added back; a second working owner's role still has to be paid for.
- 03Buyers accept documented add backs and reject recurring costs relabeled as one time, unreported cash, and projected savings.
- 04SDE is larger than EBITDA by about the cost of the owner's role, so multiples for one never apply to the other.
- 05Lenders credit only add backs they can verify, so an add back schedule tied to documents protects the price.
What are seller's discretionary earnings?
Seller's discretionary earnings, usually shortened to SDE, is the total financial benefit a business provides to one full time owner operator in a year. It starts with pretax profit and adds back the owner's compensation, certain noncash and financing costs, and expenses that are personal to the owner or will not recur under new ownership.
SDE is the earnings measure most commonly used to price owner operated small businesses. It answers a practical question a buyer has: if I buy this business and run it myself, how much cash does it generate before I pay myself, service any debt, and pay income taxes? Because nearly every small business sale starts from this figure, sellers benefit from understanding how it is built and where buyers push back.
How do you calculate SDE?
The calculation starts with net profit before income taxes from the profit and loss statement or tax return, then adds back specific categories:
- 01The owner's salary or draws, plus payroll taxes on that salary
- 02Owner benefits paid by the business, such as health insurance and retirement contributions
- 03Interest expense on business debt
- 04Depreciation and amortization
- 05Personal expenses run through the business
- 06Nonrecurring expenses that will not continue under a new owner
Only one owner's compensation is added back. If two owners both work in the business, the second owner's role still has to be filled, so a market cost for that role stays in the expenses.
What does a worked SDE example look like?
The figures below are hypothetical round numbers chosen only to illustrate the arithmetic. They do not describe any real business, and they do not suggest what any business earns or is worth.
| Line item (illustrative only) | Hypothetical amount |
|---|---|
| Net profit before income taxes | $150,000 |
| Add back: owner salary | $90,000 |
| Add back: owner health insurance | $15,000 |
| Add back: depreciation | $25,000 |
| Add back: amortization | $5,000 |
| Add back: interest on business loans | $10,000 |
| Add back: one time legal fees for a settled dispute | $8,000 |
| Add back: owner personal vehicle costs | $7,000 |
| Seller's discretionary earnings | $310,000 |
In this illustration, each add back would need support: payroll records for the salary, insurance invoices for the health coverage, the depreciation schedule from the tax return, loan statements for interest, the engagement letter and invoices for the legal matter, and a record showing the vehicle is personal rather than used for business.
The SDE figure is a starting point for a valuation discussion, not a valuation. How a buyer prices it depends on the risk and transferability of the earnings, which is covered in our guide on how much can I sell my business for.
Which add backs do buyers usually accept?
Add backs that are clearly documented and clearly would not continue under a new owner are the easiest to defend. Common examples include:
- The selling owner's salary, payroll taxes on it, and benefits, limited to one owner
- Depreciation and amortization, which are noncash accounting entries
- Interest on debt the seller will pay off at closing
- A one time legal settlement, a one time consulting project, or a documented casualty loss
- Personal expenses paid by the business that are identifiable in the records, such as a family member's phone plan or personal travel
- Rent paid to the owner above market, if the lease will be reset to market terms at closing
The common thread is documentation. Each accepted add back has a paper trail that a buyer and lender can review.
Which add backs do buyers usually reject?
Buyers and lenders are skeptical of add backs that look like ordinary operating costs relabeled. Common examples that draw rejection include:
- Expenses described as one time that appear in multiple years
- Marketing or repairs the business will need again, labeled as discretionary
- Wages for family members who perform real work that someone will have to be paid to do
- Cash revenue not reported on tax returns; a lender will not credit unreported income, and claiming it creates its own legal problems
- Estimates of savings a new owner could achieve, which belong to the buyer's projections, not to historical earnings
- Rent paid to the owner below market, which actually requires a deduction if the lease will move to market terms
- Expenses with no supporting documents
Each rejected add back reduces the earnings a buyer will price from. Owners who present aggressive add backs often see the figure cut during diligence, which can damage trust in the rest of the numbers.
How does SDE differ from EBITDA and net income?
The three measures answer different questions.
Net income is the bottom line after all expenses, including owner compensation, interest, depreciation, and taxes. It is shaped by tax planning and is rarely the figure a buyer prices from in a small business sale.
EBITDA is earnings before interest, taxes, depreciation, and amortization. It treats the cost of management as an operating expense at a market rate, so it does not add back owner compensation. EBITDA is the usual measure for larger businesses with a management team in place, and for buyers who will not work in the business themselves.
SDE goes one step further than EBITDA by adding back one owner's total compensation and benefits. For the same business, SDE is larger than EBITDA by roughly the cost of the owner's role.
Because the measures are different, multiples associated with one should never be applied to the other.
Why does documentation matter so much to lenders?
Many small business acquisitions are financed with SBA 7(a) loans. The lender's central test is whether the business's historical cash flow can cover the new debt payments with a margin of safety. Lenders build that cash flow from tax returns and financial statements, and they generally give credit only for add backs they can verify.
If a seller's SDE depends on add backs that the lender excludes, the lender's cash flow figure will be lower, the loan the lender will approve may be smaller, and the buyer may not be able to finance the agreed price. That gap usually has to be closed with more buyer equity, more seller financing, or a lower price. Our article on SBA 7(a) loans for buying a business explains lender underwriting in more detail.
The practical step for a seller is to build an add back schedule before going to market, with each line tied to a document, a ledger account, and the year it occurred.
How do you normalize owner compensation when a buyer will hire a manager?
Some buyers will not run the business themselves. A private equity group, an investor, or an existing company making an acquisition will hire a manager. For those buyers, adding back the full owner compensation overstates the earnings available, because a manager has to be paid.
Normalizing means replacing the owner's actual compensation with the market cost of the role the owner performs. In the illustration above, if the hypothetical business needed a general manager at an assumed total cost of $70,000 including payroll taxes and benefits, the adjusted earnings for a buyer who will hire that manager would be $240,000 rather than $310,000. Again, these numbers are illustrative only.
Two points matter in practice. First, the market cost of the role should reflect what the owner actually does; an owner who handles sales, operations, and estimating may be performing more than one job. Second, if the owner currently pays themself well below market, a buyer will normalize upward, which reduces earnings. Presenting both SDE and a normalized figure shows buyers that the seller understands how different buyer types will view the business.
How many years of SDE do buyers review?
Buyers and lenders rarely price from a single year. A typical review covers the last three full years plus the current year to date, with SDE calculated the same way for each period.
Looking across several years shows the direction of earnings. A business with steady or rising SDE gives a buyer more confidence than one whose most recent year jumped after several flat ones. When the latest year is the strongest, buyers will ask what drove the change and whether it will last. When one year was weak because of an identifiable event, such as a temporary closure or the loss of an account that has since been replaced, the explanation should be written down and supported.
Consistency in method matters as much as the figures. An add back taken in one year and not in another, or a category of expense that moves between years without explanation, will draw questions. Preparing every period on the same basis, using the same chart of accounts, shows a buyer the trend without distortion.
Who should prepare the SDE calculation?
Your CPA can produce clean financial statements and confirm the accuracy of the underlying figures. A business broker can recast those statements into SDE the way buyers and lenders will view them and flag add backs likely to be challenged.
Forge's business valuation service includes an SDE recast and a broker opinion of value for owners considering a sale. A broker opinion of value is not a certified appraisal; if you need a valuation for tax, legal, or court purposes, you need a credentialed appraiser. For the full sale process, see our guide to selling your business.