What is SDE? Seller's Discretionary Earnings explained
SDE is the number that tells you what a small business really earns for its owner. Here's how it works, why add-backs matter, and how to check one.
What is SDE? Seller’s Discretionary Earnings explained
When you look at a small business for sale, the asking price is tied to one number more than any other: SDE, or seller’s discretionary earnings. It’s the number a broker quotes, the number a lender sizes a loan against, and the number you’ll negotiate around. If you’re buying your first business, it’s the first thing worth understanding.
Here’s the plain version. SDE is what the business actually earns for one owner-operator, once you strip out the choices the current owner made that you wouldn’t have to.
Why net income isn’t the answer
Pull up a small business’s tax return and you’ll find a net income figure, often surprisingly small. A business doing $900,000 in revenue might show $80,000 in profit. That looks thin. But that number is misleading, on purpose.
Small business owners run expenses through the company that aren’t really costs of running it. They pay themselves a salary. They put a personal vehicle on the books. They expense a phone, some travel, sometimes health insurance or a family member’s wages. None of that is wrong, it’s normal, and often it’s smart tax planning. But it means the net income on the return understates what the business actually produces.
SDE corrects for that. It starts with net income and adds back the things a new owner wouldn’t inherit.
What gets added back
The typical add-backs are:
- The owner’s salary. You’ll pay yourself, but for valuation the business is measured as if one owner runs it, so the current owner’s compensation goes back in.
- Personal expenses run through the business. The vehicle, the phone, the travel that was really personal. Real money, but not a cost of the business.
- Depreciation and amortization. Accounting entries, not cash leaving the business.
- Interest. Tied to the current owner’s debt, which you won’t inherit in an asset sale.
- One-time expenses. A lawsuit, a one-off equipment purchase, anything that happened once and won’t repeat.
Add those back to net income and you get SDE. That $80,000 net income business might have $240,000 in SDE once you rebuild it. That’s the number the deal actually runs on.
Why add-backs are where deals go wrong
Here’s the catch, and it’s the reason to slow down. Add-backs are where a seller’s number and the real number drift apart.
Every add-back makes the business look more profitable, so a seller has every incentive to be generous with them. Some are legitimate. Some are a stretch. A salary that’s genuinely discretionary is a fair add-back. A “one-time” expense that shows up in all three years isn’t one-time, and a lender will strip it right back out.
So when you see an SDE figure, the question isn’t just “how big is it.” It’s “is every add-back in it real and defensible.” A $250,000 SDE built on soft add-backs is worth less than a $200,000 SDE you can stand behind. This is the single most common place a first-time buyer overpays: taking the seller’s SDE at face value.
How to check an SDE
Ask for the detail behind it. A seller quoting SDE should be able to show you the build: here’s net income from the return, here’s each add-back, here’s the receipt or the reason for each one. If they can’t itemize it, that’s a flag. If a “personal” expense can’t be documented, don’t count it. If an add-back recurs every year, it’s a real cost, not an add-back.
Then rebuild it yourself from the tax returns and the profit-and-loss statements, line by line, and see if you land where the seller landed. The gaps are where the negotiation is.
The number under the whole deal
Once you have a defensible SDE, everything else follows from it. The valuation is a multiple of SDE, usually somewhere between two and three times for a small business. The loan a bank will give you is sized against it. Your own take-home, after debt service, comes out of it. Get SDE right and the rest of the analysis is sound. Get it wrong and every number downstream is wrong too.
That’s why it’s worth the care. SDE isn’t an accounting formality, it’s the foundation the entire purchase decision sits on.
Rebuilding SDE from a seller’s tax returns and P&Ls, checking every add-back against the source, is exactly the work Valtize does. Upload the financials and it shows you the SDE build line by line, so you can see which add-backs hold up before you make an offer.