What Is Seller's Discretionary Earnings (SDE)?

The definition

SDE is the total financial benefit one full-time owner-operator gets from the business in a year. It starts with pre-tax net profit and adds back everything the owner took out or ran through the company that a new owner would not have to spend.

The standard build looks like this. Start with net income before taxes. Add back one owner's salary and payroll taxes. Add back interest expense, because the buyer will have their own financing. Add back depreciation and amortization, which are accounting entries, not cash. Add back the owner's personal expenses that went through the business. Add back one-time or non-recurring costs. The result is SDE.

A simple example. A business shows $120,000 in net profit on its tax return. The owner paid herself $90,000 in salary. The business paid $15,000 in interest on an equipment loan and took $25,000 in depreciation. The owner's health insurance, personal vehicle, cell phone, and a family member's phone ran through the business at $18,000. She also spent $12,000 on a lawsuit that settled and will not recur. SDE is $120,000 plus $90,000 plus $15,000 plus $25,000 plus $18,000 plus $12,000, which is $280,000.

A buyer prices that business on $280,000, and at a 2.5 multiple the difference between the two figures is $400,000 in sale price.

Why buyers use it

A buyer of a small business is buying a job and an income stream at the same time. SDE tells them what the job pays before they decide how to finance it, what to pay themselves, and what to reinvest. Two businesses with the same SDE are worth roughly the same to that buyer even if one owner takes a $200,000 salary and the other takes $40,000 and leaves the rest in the company.

Lenders use it the same way. An SBA lender underwriting an acquisition loan starts with SDE, subtracts a reasonable salary for the new owner, and checks whether what is left covers the loan payment with room to spare. If SDE is overstated, the loan does not get approved, and the deal dies at the bank instead of at the negotiating table.

One owner, not two

SDE adds back the compensation of one owner. If a husband and wife both work full time in the business and both take a salary, only one salary gets added back. The other has to stay in as an expense, because the buyer will have to hire someone to do that job. The same applies to an owner who works 70 hours a week doing two people's work. A buyer will price in the cost of the second person.

A lot of overstated SDE comes from this. An owner sees "add back owner salary" and adds back everyone in the family. Buyers and their accountants catch it in diligence, and the price comes down at the worst possible time.

What counts as an add-back

The rule is simple. An add-back has to be an expense the new owner will not have, and it has to be provable. Personal auto, personal travel, personal meals, family members on payroll who do not work, health insurance for the owner, retirement contributions for the owner, and personal cell phones are common. A one-time legal settlement, a one-time equipment repair, moving costs, or a bad debt write-off from a customer that went out of business can all qualify if they do not recur.

What does not count. Cash sales that were never reported. Expenses the buyer will still have, like the second family member who runs the front desk. Rent, if the buyer will pay the same rent. Repairs that happen every year. Marketing, unless the owner can show it was a one-time experiment. "Owner perks" without receipts.

Every add-back needs a paper trail. The general ledger line, the invoice, the credit card statement. A buyer will accept a documented $8,000 personal travel add-back. They will not accept a $40,000 line labeled "owner discretionary" with nothing behind it, and once they see one soft add-back they discount all the others.

SDE versus EBITDA

EBITDA is earnings before interest, taxes, depreciation, and amortization. It is SDE without the owner's salary added back. In other words, EBITDA assumes someone is being paid a market salary to run the company, and the earnings are what is left after that.

Businesses valued on EBITDA are usually larger, with a management team and an owner who is not doing a job in the business every day. The multiples applied to EBITDA are higher than the multiples applied to SDE, often 4 to 6 versus 2 to 3.5, because the buyer is getting earnings without having to work for them. If you take SDE, subtract a market salary for a general manager, and apply an EBITDA multiple, you often land in about the same place as the SDE calculation. The two methods are describing the same business from two angles.

We use SDE as the lead basis for most owner-operated businesses and show adjusted EBITDA alongside it, so a buyer coming from either world can see the number they are used to.

Three years, weighted

Buyers look at three years of SDE, not one. A business with SDE of $200,000, $250,000, and $300,000 over three years is priced differently than one that went $300,000, $250,000, $200,000, even though the average is the same. The first is growing and the last year carries the most weight. The second is declining and the buyer will ask why.

The trailing twelve months matter most. If the current year is running ahead of last year, a year to date P&L with the same period from the prior year lets a buyer price in the growth. If it is running behind, expect the question.

A worked example with three years

Here is how the schedule looks for a business over three years, the way a buyer and a lender will read it.

Year one: net income $95,000, owner salary $80,000, interest $12,000, depreciation $20,000, personal expenses $14,000, one-time items $0. SDE $221,000.

Year two: net income $110,000, owner salary $85,000, interest $10,000, depreciation $22,000, personal expenses $16,000, one-time legal settlement $9,000. SDE $252,000.

Year three: net income $140,000, owner salary $90,000, interest $8,000, depreciation $24,000, personal expenses $15,000, one-time items $0. SDE $277,000.

The trend matters as much as the numbers. This business grew SDE about 12 percent a year, and the current year to date is running ahead of last year. A buyer will weight the most recent year and the trailing twelve months, and will price closer to the top of the multiple range because the direction is up. The same three years in reverse order would produce a lower multiple and a longer conversation about why.

Notice the one-time legal settlement in year two. It is on the schedule with a description, and the settlement agreement is in the data room. That is what makes it an add-back rather than an argument.

Mistakes that cost sellers money

Adding back the full rent when the owner also owns the building. The buyer will pay rent to someone, so the add-back is only the amount above market rent, if any.

Adding back a manager's salary on the theory that the buyer will run the business themselves. Buyers and lenders price the business as it runs today, with the manager in place.

Forgetting to add back items that qualify. Owners who have run personal expenses through the business for years often do not remember all of them. The general ledger does. Going line by line finds add-backs the owner forgot, and each one is worth two to three times its amount.

Presenting SDE from a P&L that does not tie to the tax return. Lenders finance the return. If the return is lower, the return is the number.

What you can do about it now

Start the SDE schedule a year before you sell, not the week the first buyer asks. Go through the general ledger line by line with your accountant and tag every expense a new owner would not have. Keep the receipts. Stop running new personal expenses through the business if they will be hard to explain. If you have been underpaying yourself, it does not hurt you, since the salary gets added back anyway. If you have been paying a family member who does not work, that add-back needs documentation of what they do not do.

When we take a business to market, the SDE schedule goes into the offering memorandum with every add-back listed and sourced. Buyers who see that work done cleanly move faster and negotiate less, because there is nothing to find.