What is Seller's Discretionary Earnings?

Seller's Discretionary Earnings (SDE) is the most important number in small business valuation. It represents the total financial benefit available to a single owner-operator of a business — and it's the foundation for how most businesses under $5M are priced.

If you're buying a business, you need to understand SDE cold. In this guide, I'll break down exactly what SDE is, how to calculate it, what qualifies as an add-back, and how it differs from EBITDA.

The SDE Formula

The basic formula for Seller's Discretionary Earnings is:

In simpler terms: SDE is the total cash the business generates for a working owner, before accounting for how that owner chooses to pay themselves or structure expenses.

SDE Calculation Example

Let's walk through a real example. Imagine a landscaping company with these financials:

If this business sold at a 3.0x multiple, the asking price would be approximately $960,000.

Common SDE Add-Backs

Not sure what counts as an add-back? Here's a comprehensive list of items that typically get added back to net income when calculating SDE:

Owner Compensation & Benefits

• Owner's salary/wages (W-2 or draws)
• Owner's payroll taxes (employer portion)
• Owner's health, dental, vision insurance
• Owner's life insurance
• Owner's retirement contributions (401k, SEP, etc.)
• Owner's personal vehicle expenses (portion used personally)
• Owner's cell phone (personal use portion)
• Meals & entertainment (personal portion)
• Family members on payroll who don't work (or are overpaid)

Non-Cash Expenses

• Depreciation
• Amortization

Financing-Related

• Interest expense (buyer will have different financing)
• Principal payments on loans

One-Time or Non-Recurring Items

• Legal fees for lawsuits (if settled/unusual)
• One-time consulting projects
• Moving or relocation expenses
• Start-up costs that won't recur
• Major equipment repairs (unusual, one-time)
• Settlement payments

Discretionary Expenses

• Above-market rent to related party (if owner owns building)
• Charitable donations
• Personal travel expensed through business
• Club memberships (personal, not business-essential)
• Hobby expenses run through business

SDE vs. EBITDA: What's the Difference?

You'll hear both terms thrown around. Here's the key distinction:

The key insight: SDE includes owner compensation because the buyer is replacing the owner and will receive that compensation. EBITDA excludes owner compensation because the assumption is professional management is in place and will continue to be paid.

When to Use Each

Use SDE when:

• Revenue under $5M
• Owner works full-time in the business
• The buyer will replace the owner as the operator
• There's only one working owner

Use EBITDA when:

• Revenue over $5M (typically $10M+)
• Business has professional management in place
• Multiple owners or absentee ownership
• Buyer is a financial sponsor or strategic acquirer

Why SDE Matters for Valuation

SDE is the foundation for small business valuation because it answers the fundamental question: "How much cash does this business generate for the person who runs it?"

The valuation formula is simple:

The multiple depends on industry, risk, growth, and other factors (typically 2.0x-4.0x for most SMBs). But SDE is the foundation. Get SDE wrong, and your entire valuation is wrong.

Common SDE Mistakes

• Over-aggressive add-backs: Adding back expenses that actually need to continue (like reasonable owner salary replacement)
• Ignoring replacement costs: If you need to hire a manager to replace the owner, that's a real cost
• Trusting seller's numbers: Always verify add-backs with documentation
• Missing working capital: SDE doesn't account for cash tied up in inventory or receivables
• Confusing SDE with cash flow: SDE is a proxy, not the actual cash you'll take home
• One-year myopia: Look at 3 years of SDE to understand the trend

SDE FAQ

What if the owner doesn't take a salary?

Many small business owners take draws or distributions instead of W-2 salary. You still add back whatever compensation they received, regardless of how it was structured. Look at distributions, draws, and any personal expenses paid by the business.

How do I verify add-backs?

Ask for documentation: receipts, credit card statements, payroll records, personal use logs for vehicles. If the seller can't prove it, it's not an add-back. In the spirit of conservatism, verify everything.

What's a "reasonable" owner salary add-back?

The entire owner salary is added back to calculate SDE. However, when evaluating the deal, you should estimate what you'd need to pay a manager to replace the owner — that's a real cost that reduces your actual cash flow.

What about multiple owners?

If there are multiple working owners, add back only ONE owner's compensation. The assumption is that you (the buyer) are replacing one owner. If both owners work full-time and you need both to run the business, you'll need to account for replacement costs.

Does SDE include rent to a related party?

If the owner also owns the real estate and charges above-market rent, you can add back the excess portion. If rent is at market, no add-back. This requires researching comparable rents in the area.

Next Steps

Now that you understand SDE:

1. Use our SDE Calculator to analyze any business you're evaluating
2. Practice calculating SDE on listing financials from BizBuySell
3. Learn about SBA financing — debt service coverage depends on SDE
4. Join the newsletter for weekly deal breakdowns and frameworks

Understanding SDE is the first step to understanding valuation. Master this, and you're already ahead of 90% of first-time buyers. Doers do.