Seller’s Discretionary Earnings (SDE), Explained

Your tax return says that your business made $60,000 last year. So that's what you should use to value your business, right?

Well, it turns out — not exactly. If you're a small business owner, chances are that the actual number you should use is called Seller's Discretionary Earnings, or SDE. SDE could be the single most important number for you if you're considering selling your business.

Intro

I'm Ed, I'm a business broker and the founder of Sundance Financial. Today I'm going to walk you through exactly what SDE is, how to calculate it, and the mistakes I often see business brokers and owners make that cost them real money at the closing table.

What Is Sde?

In a nutshell, SDE is trying to answer one simple question:

How much cash could a new owner draw from the business if they ran it at arm's length?

In a formula, SDE roughly translates to:

SDE = EBITDA + Owner's Salary and Benefits + Personal and Discretionary Expenses ± Arm's-Length Adjustments

There are three ideas buried in this definition:

1. How much cash
2. Could a new owner draw
3. If they ran the business at arm's length

Let's unpack these one at a time.

1. The Starting Point: Ebitda

The starting point for SDE is your pre-tax profit — specifically a version of it called EBITDA.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

Why is EBITDA so important? Two reasons:

• Buyers care about cash flow. Depreciation and amortization are inherently non-cash expenses.
• Buyers want to understand the cash flow of the business itself, independent of the financing and tax decisions made by management — which are going to be completely different under new ownership anyway.

EBITDA gives you a clean picture of the cash a business is generating from running itself. That's why it's the foundation of SDE.

2. Add-Backs: The Owner'S Benefit

Here's where SDE gets interesting. As a small business owner, you'll often run your business to optimize for your own personal situation — not necessarily to paint a flattering picture for a future buyer. That's rational, but it does mean that your tax returns don't necessarily represent what the business actually generates.

Owner's Salary

The classic example is your salary. If you paid yourself $70,000 last year, that shows up in your P&L as an expense, bringing your net profit down. Another owner with the exact same business might only pay themselves $30,000 to optimize for their personal tax situation. That means the business they operate would show $40,000 more profit than the business you operated — the exact same business with different reported earnings.

But paying yourself a salary out of your own business is really just shifting money from your left pocket to your right. The economic reality of the business hasn't changed at all. So to properly capture the total economic benefit a new owner would receive — and to compare across businesses on equal footing — we add back the owner's salary to our SDE calculation.

Personal and Discretionary Expenses

Similar logic applies to all the other personal expenses that you run through the business:

• Health insurance
• The truck you drive on weekends
• Your personal phone
• Meals
• Charitable donations

None of these expenses are actually required to keep the business running, and every owner will make slightly different decisions based on their personal situation. So to adjust for all of that, we simply add it all back to SDE.

That's exactly the point of an add-back. It's a legitimate way of showing buyers the total economic benefit that the business produces.

3. Arm'S-Length Adjustments

The arm's-length adjustment is one that people often miss. A lot of small businesses have sweetheart deals baked into them that wouldn't survive a change in ownership.

Example 1 — Below-market rent. Suppose your friend owns the building you operate out of and charges your business $1,500 a month in rent, versus a market rate closer to $3,500. That's a $24,000-a-year discount that a new buyer is most likely going to lose once they take over. To adjust for this, we'd reduce SDE by $24,000.

Example 2 — Above-market payroll. Say your brother-in-law is on payroll at $80,000 but only really does about $30,000 of actual work. A new owner could replace him at a market rate of $30,000. In this case, we'd adjust SDE up by $50,000.

The principle is simple: SDE should reflect what the business would actually look like operating on standard market terms. No favors, no family deals, no cutting yourself a break. Everything at arm's length.

DETOUR: SDE vs. EBITDA

You'll hear buyers and brokers talk about EBITDA on its own as well, so what's the difference?

The biggest difference is that EBITDA doesn't add back the owner's salary, whereas SDE does. That sounds like a small difference, but it changes the type of business each metric is typically used for:

• SDE is the standard for small businesses, typically with under $5 million in sales, where the owner is still heavily involved in day-to-day operations.
• EBITDA takes over as the business gets larger. At about the $5 million mark, you'll typically have a professional management team in place, the business is more institutionalized, and the owner's personal situation has less and less bearing on the numbers. At that point, EBITDA becomes a much simpler metric to compare across businesses.

Worked Example

Let's tie this all together with a quick example for a small service business:

Item	Amount
EBITDA	$150,000
+ Owner's salary	$80,000
+ Personal vehicle expenses	$7,000
+ Personal health insurance	$8,000
+ Personal cell phone	$1,800
+ Charitable donations	$3,200
− Arm's-length rent adjustment (paying $10K vs. $25K market)	($15,000)
SDE	$235,000

Three Things To Watch Out For

1. Add-backs must be defensible. If an expense is actually something a new owner would have to spend to keep the business running, it's not an add-back — it's a cost of doing business. Some brokers try to stuff everything into the add-back column to pump up the asking price. Buyers and their lenders will see through this, and the minute they stop trusting your numbers, the deal is as good as dead.

2. SDE is calculated across multiple years. Buyers typically ask for at least three full years of financial performance, plus year-to-date financials. One good year on its own doesn't tell a buyer much — they want to see the trend.

3. SDE is not your take-home pay. From that $235,000 in our example, a new owner would still need to pay themselves a salary, service any debt they took on to buy the business, and reinvest some funds back into the company. Think of SDE as the total pool of cash available — not your spending money.

Wrap-Up

So that's SDE. It's not your tax return. It's not your net profit. It's the total economic benefit that a business delivers to an owner-operator who's running it on an arm's-length basis.

If you want to go deeper on this, I've written a detailed guide on my website that goes through everything step by step — link in the description below.

I'm also going to be posting a practical companion video where I pull out a real tax return and walk you through the SDE calculations line by line, so you can follow along at home. Hit subscribe so you don't miss it.

And if you want to talk through what your SDE looks like or what your business might be worth, I offer a free, no-obligation consultation. Just book through my website — link in the description.

Again, I'm Ed from Sundance Financial. I'll see you in the next one.