What is SDE? A Complete Guide to Seller Discretionary Earnings

If you're considering buying or selling a small business, you've likely encountered the term "SDE" or Seller Discretionary Earnings. But what exactly does it mean, and why is it so important in small business valuations?

Understanding Seller Discretionary Earnings

Seller Discretionary Earnings (SDE) is the most common measure of profitability used in small business sales. It aims to answer one critical question:

This metric is essential because it provides a normalized view of what a business truly earns, accounting for the unique ways small business owners often structure their finances.

Let's break down this definition into its three key components:

1. How Much Cash: Starting with EBITDA

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) serves as the foundation for calculating SDE. It's a widely accepted proxy for operational cash flow in finance because it measures earnings before:

• Non-cash expenses like depreciation and amortization
• Financing decisions like interest payments
• Tax obligations that vary by owner

While EBITDA doesn't perfectly capture cash flow—for example, if you make a sale on credit, that revenue appears in EBITDA even though you haven't yet collected the cash—these differences typically smooth out over time, making it a reliable starting point.

2. Could a New Owner Receive: Adding Back Owner Benefits

Small business owners often make financial decisions based on their personal tax situations rather than pure business economics. This creates variations that can obscure the true earning potential of a business.

Common examples include:

• Owner compensation: Drawing a larger or smaller salary than market rate
• Personal expenses: Running personal costs through the business (vehicle expenses, travel, mobile phones, insurance, etc.)
• Discretionary spending: Expenses that a new owner does not need to incur (e.g. charitable donations)

SDE normalizes these differences by adding back owner salary and discretionary expenses, revealing what's actually available to an owner-operator.

3. On an Arm's Length Basis: Adjusting for Special Arrangements

Many small businesses operate with sweetheart deals or non-market arrangements that wouldn't transfer to a new owner. These require adjustment to reflect true market conditions.

Common adjustments include:

• Non-market rent: If the current owner also owns the property and charges below-market rent (or no rent at all), this gets adjusted to reflect what a new owner would pay. The opposite of this scenario is also true and common
• Family employment: Friends or family working for non-market wages (either above or below market rate) are adjusted to reflect what an independent owner would pay for the same role. If the friend or family member's role is not necessary in the business, their entire salary is added back
• Related party transactions: Any other special arrangements that wouldn't continue under new ownership—for example, overly favourable supply agreements or customer contracts

How to Calculate SDE: The Formula

The calculation follows a straightforward 'addback' methodology:

Example Calculation

Let's look at a practical example:

• EBITDA: $150,000
• Owner's salary: $80,000
• Personal expenses (auto, phone, etc.): $12,000
• Below-market rent (market rate is $30,000, paying $15,000): +$15,000 adjustment

This means a new owner-operator could expect to take home approximately $257,000 in discretionary earnings—but they would need to pay themselves a salary from this amount and pay market-rate rent.

Why SDE Matters for Business Valuation

SDE is the preferred metric for valuing small businesses (typically those under $5 million in revenue) because:

• It reflects owner-operator reality: Most small business buyers will actively work in the business
• It normalizes quirks: Every small business has unique financial arrangements; SDE levels the playing field
• It's comparable: SDE allows meaningful comparisons between different businesses and industries. You can compare your SDE against industry benchmarks to see how your business stacks up
• It drives valuation multiples: Small businesses typically sell for 2-4x SDE, depending on industry and other factors

SDE vs. EBITDA: When to Use Each

While SDE is standard for small businesses, larger businesses (typically over $5 million in revenue) use EBITDA for valuation.

Key Takeaways

Seller Discretionary Earnings provides a true picture of small business profitability by normalizing for owner-specific financial decisions and arrangements. Understanding SDE is essential whether you're buying, selling, or valuing a small business—it's the common language of small business transactions.