Direct answer
To calculate SDE (Seller's Discretionary Earnings): start with net income from the P&L, then add back (1) owner compensation including payroll taxes and benefits, (2) interest expense, (3) federal and state income taxes, (4) depreciation, (5) amortization, and (6) defensible discretionary add-backs (personal vehicle, above-market family salaries, one-time fees, personal travel). Document each add-back with underlying transaction support. The result is the cash an owner-operator would actually receive from the business each year.
The formula
SDE is mechanical. Net income plus six categories of add-backs.
The formula:
SDE = Net Income + Owner Compensation + Interest + Taxes + Depreciation + Amortization + Discretionary Add-Backs
Calculate this for the most recent three years. Recent year carries the most weight, but the trend matters too.
Worked example: ABC Plumbing
Walk through the full calculation on a realistic example.
Assume ABC Plumbing reports the following for the most recent fiscal year:
| Line Item | Amount |
|---|
| Revenue | $2,800,000 |
| Cost of Goods Sold | $1,400,000 |
| Gross Profit | $1,400,000 |
| Operating Expenses | $1,100,000 |
| Operating Income | $300,000 |
| Interest Expense | $25,000 |
| Income Before Tax | $275,000 |
| Income Tax | $72,000 |
| Net Income | $203,000 |
Embedded in operating expenses are the following:
- Owner salary: $180,000 + payroll taxes and benefits of $35,000 = $215,000 total owner compensation
- Depreciation: $65,000
- Amortization: $8,000
- Spouse salary (works 10 hours/week, market rate would be $20K, paid $55K): $35,000 add-back
- Personal vehicle (truck used 30 percent for business): $12,000 personal portion
- Personal travel categorized as business: $8,000
- One-time legal settlement (resolved litigation, not expected to recur): $22,000
- Country club dues (personal): $9,000
SDE calculation:
| Component | Amount |
|---|
| Net Income (base) | $203,000 |
| + Interest expense | $25,000 |
| + Income tax | $72,000 |
| + Owner compensation (total) | $215,000 |
| + Depreciation | $65,000 |
| + Amortization | $8,000 |
| + Spouse above-market comp | $35,000 |
| + Personal vehicle | $12,000 |
| + Personal travel | $8,000 |
| + One-time legal | $22,000 |
| + Country club dues | $9,000 |
| = SDE | $674,000 |
Applying a multiple
Once you have SDE, multiply by an industry-appropriate multiple.
For a plumbing business with $674K SDE, low-medium customer concentration, low-medium growth, and full-time owner involvement: industry baseline 3.0x, adjustments roughly neutral. Valuation: approximately $2.0M.
Documentation requirements
Each add-back needs to be traceable. Buyers will ask.
For each add-back, document:
- The GL account it came from
- The specific transactions or amounts
- A one-line explanation of why it qualifies as an add-back
- Supporting documentation (receipts, contracts, etc.) available on request
Common SDE calculation mistakes
- Forgetting payroll taxes and benefits. Owner compensation includes the employer payroll tax (FICA, Medicare, unemployment) and benefits (health insurance, 401k contributions). These are part of total owner comp.
- Adding back rent paid to owner. If the business pays rent to an entity you own, the add-back is the difference between paid rent and market rent — not the full rent payment.
- Confusing one-time with recurring. A legal expense that occurs every other year is not a one-time add-back.
- Adding back depreciation on assets that need ongoing replacement. If a vehicle has to be replaced every 5 years, the depreciation represents a real economic cost over the long run. EBITDA does this correctly; SDE typically does not.
- Aggressive owner comp add-back. Adding back the entire family compensation when only the portion above market is defensible.
Frequently asked questions
What is the difference between SDE and seller cash flow?
They are functionally the same. Different practitioners use different terminology. SDE is the most standardized term and the one most buyers and lenders prefer.
Should I add back depreciation if I need to keep buying trucks?
For SDE, yes (it is a non-cash item). For valuation accuracy, the buyer will adjust for ongoing capital expenditure needs in their own analysis. EBITDA partially addresses this by reflecting actual replacement cost.
How does the IRS view SDE add-backs?
They do not. SDE add-backs are a presentation methodology for valuation purposes, not a tax position. The IRS cares about what you reported, not what your add-back schedule looks like.
Can I add back marketing expense?
Generally no. Marketing is an operating expense. Even if you think the new owner could cut it, marketing supports the revenue you reported. Adding it back overstates SDE.
How many years of SDE should I calculate?
Three. Present as a trend: most recent year, prior year, two years prior. Buyers weight the most recent year most heavily but want to see the pattern.
This article is general educational information and not financial, tax, or legal advice. Specific transactions require your own attorney, CPA, and an experienced M&A advisor.