Seller's Discretionary Earnings (SDE), explained.

What SDE is, in plain terms

SDE answers a simple question: how much money does an owner-operator actually make from this business per year, before financing and tax decisions?

SDE was developed because reported net income is a poor measure of what an owner-operator actually earns. Tax strategy depresses reported income. Owner compensation is often non-market. Personal expenses run through the business reduce net income further. SDE corrects for all of that.

How to calculate SDE

The formula is mechanical. The interesting work is identifying which add-backs are defensible.

Start with reported net income from the P&L (or the tax return — preferably both, reconciled). Add back:

1. Owner compensation. Salary, bonuses, payroll taxes, and benefits paid to the primary owner.
2. Interest expense. The new owner will have their own financing structure.
3. Taxes. Federal and state income taxes (not sales tax, payroll tax, or property tax — those are operating costs).
4. Depreciation. Non-cash; the new owner will have their own depreciation schedule.
5. Amortization. Non-cash; same logic as depreciation.
6. Discretionary add-backs. Specific items, documented and defensible (see below).

Which add-backs are defensible

A defensible add-back is one a buyer auditor will accept after looking at the underlying documentation.

The common categories:

• Personal vehicle expenses. The truck or SUV expensed through the business that you would own personally otherwise.
• Family member compensation above market. A spouse on payroll for $80K when the market rate for the role is $40K — the $40K delta is the add-back.
• One-time professional fees. Legal fees for a specific lawsuit, accounting fees for a one-time IRS audit, consulting on a project that will not recur.
• Personal travel and entertainment. Country club dues, personal vacations expensed as business travel, family vacations characterized as conferences.
• Owner medical and insurance. Owner health insurance and life insurance, where these are personal expenses.
• One-time capital expenditures expensed. A piece of equipment expensed in error that should have been capitalized.

What is NOT a defensible add-back

If you cannot point to a check or a transaction supporting it, it is not an add-back.

• Marketing or advertising spend you think the new owner could cut.
• Employee wages you think the new owner could reduce.
• Rent, even if you own the building (handle this through separate normalization).
• What you would pay yourself if you were the buyer (the add-back is what you actually pay, not aspirational comp).
• One-time expenses that are actually recurring (they happen every year, just for different reasons).

Documenting the add-back schedule

The add-back schedule is its own document, typically a spreadsheet, that shows each add-back with the underlying transaction support.

For each add-back: the dollar amount, the GL account it came from, the underlying transactions, and a one-line explanation. The schedule typically covers three years (most recent fiscal year plus two trailing years). Buyers and their quality of earnings analysts will recompute SDE from scratch and challenge each add-back individually.

SDE vs. EBITDA — when each applies

SDE for owner-operated businesses. EBITDA for businesses with professional management. The transition zone is roughly $2-3M in sale value.

The mechanical difference: SDE adds back the entire owner compensation. EBITDA only adjusts to a market-rate manager replacement cost. For an owner-operated $1.5M business where the owner pays themselves $200K, SDE might be $500K and EBITDA might be $370K (after adding $130K for a market-rate GM).

The reason this matters: buyers in the under-$2M range are typically individual buyers evaluating the business as a job replacement plus an investment. SDE captures both. Buyers in the over-$3M range typically plan to hire professional management, so EBITDA is what reflects their economic reality.

Frequently asked questions