What Is Seller's Discretionary Earnings (SDE)?

If you own a business worth less than $5 million, SDE is the single most important number in determining what your business will sell for. Not revenue. Not profit. SDE — Seller's Discretionary Earnings. It's the total annual cash flow available to an owner-operator, and it's the number that buyers multiply to arrive at your purchase price.

I'm constantly surprised by how many business owners don't know their SDE. They know their revenue. They know their net income. But they've never calculated the number that actually drives their valuation. Let me fix that.

The SDE Formula

SDE starts with your net income and adds back everything that is either discretionary (the new owner might choose differently) or non-cash. The formula:

SDE = Net Income + Owner's Salary + Owner's Benefits + Interest + Depreciation & Amortization + One-Time / Non-Recurring Expenses

Let me walk through each component, because the details matter.

Net Income.This is your bottom line — what's left after all expenses. Start with the net income on your tax return (Schedule C for sole proprietors, Form 1120S for S-corps, Form 1120 for C-corps). This is your foundation.

Owner's Salary and Compensation.Add back everything you pay yourself: W-2 wages, guaranteed payments, distributions taken as compensation, bonuses. If you're an S-corp owner paying yourself $150K in W-2 wages plus $50K in distributions, both get added back. The logic: the new owner will determine their own compensation, so yours is discretionary.

Owner's Benefits.Health insurance premiums paid by the business for you and your family. Your vehicle expenses (or the business portion). Your retirement plan contributions. Life insurance. Country club dues if run through the business. Cell phone, travel that's partially personal — anything the business pays for that benefits you personally.

Interest Expense. Add back all interest on business debt. The buyer will have their own capital structure — your debt is irrelevant to the cash-flow available to them.

Depreciation and Amortization.These are non-cash charges that reduce your taxable income but don't represent actual money leaving the business. Add them back. (Note: if you have significant equipment that will need replacement, a buyer may subtract a "maintenance capex" estimate — but that's a separate conversation.)

One-Time and Non-Recurring Expenses.A lawsuit settlement. Moving costs. A one-time equipment repair. The cost of remodeling your office. These are expenses that won't repeat under new ownership and should be added back. But be careful — buyers and their advisors will scrutinize these heavily.

A Full Worked Example

Let's say you own a commercial cleaning company. Here's your P&L:

• Revenue: $1,200,000
• Cost of Goods (labor, supplies): -$720,000
• Gross Profit: $480,000
• Owner Salary (W-2): -$120,000
• Rent: -$36,000
• Insurance: -$18,000
• Vehicle Expenses (2 trucks): -$24,000
• Owner Health Insurance: -$18,000
• Office & Admin: -$12,000
• Marketing: -$15,000
• Depreciation: -$22,000
• Interest on Equipment Loan: -$8,000
• Legal (one-time contract dispute): -$25,000
• Owner Cell Phone: -$2,400
• Owner Auto (personal use portion): -$6,000
• Net Income: $173,600

Now let's calculate SDE:

• Net Income: $173,600
• + Owner Salary: $120,000
• + Owner Health Insurance: $18,000
• + Owner Cell Phone: $2,400
• + Owner Auto (personal): $6,000
• + Interest: $8,000
• + Depreciation: $22,000
• + One-Time Legal: $25,000
• SDE: $375,000

The tax return showed $173K in net income. The real cash flow available to an owner-operator is $375K. That's the number a buyer multiplies. At a 2.5x multiple (typical for a well-run cleaning company), this business is worth roughly $937K. If you had valued it on net income alone at 2.5x, you would have gotten $434K — less than half the right answer.

Legitimate Add-Backs vs. Add-Backs That Will Get Challenged

Not all add-backs are created equal. Buyers and their Quality of Earnings firms will push back on anything that looks aggressive. Here's what flies and what doesn't.

Almost always accepted: Owner salary and bonuses, owner health insurance, owner retirement contributions, interest, depreciation, clearly documented one-time expenses (lawsuit, natural disaster repair, relocation).

Accepted with documentation:Owner vehicle expenses (need mileage logs showing personal vs. business), travel that's partially personal (need clear allocation), family members on payroll who don't perform real duties (need to show the role can be eliminated).

Will get challenged or rejected:"We're investing in growth" add-backs (extra marketing spend you claim won't recur — buyers don't buy it). Inflated owner salary (claiming you were underpaid at $80K when market rate for your role is $120K, effectively adding back $40K that isn't real). "Synergy" add-backs (cost savings the buyer might achieve — those are the buyer's value, not yours). Revenue run-rate adjustments ("we just signed a big contract" — show it in the numbers first).

The rule of thumb: if you can't show a skeptical CPA the supporting documentation for an add-back in under five minutes, it's going to get challenged. And if your SDE relies heavily on aggressive add-backs, buyers will discount your entire set of numbers — not just the questionable items.

How to Calculate SDE From Your Tax Return

You don't need a CPA to get a rough SDE number. Here's how to do it yourself, depending on your entity type:

Sole Proprietor (Schedule C):Start with Line 31 (net profit). Add back any owner-related expenses from Lines 9 (car/truck), 15 (insurance), 16 (interest), 13 (depreciation), and any personal expenses buried in "Other Expenses" on Line 27.

S-Corp (Form 1120S):Start with Line 21 (ordinary business income). Add back officer compensation from Line 7. Add back interest (Line 13), depreciation (Line 14), and any owner benefits buried in "Other Deductions." Also add back any distributions that function as additional compensation.

Partnership/LLC (Form 1065): Start with Line 22 (ordinary business income). Add back guaranteed payments to partners from Line 10. Add back interest and depreciation. Review the K-1s for any additional owner-related items.

This will get you within 10-15% of a professionally calculated SDE. For an exact number, work with a CPA who understands M&A add-backs — the nuances matter when you're negotiating a sale.

SDE vs. EBITDA: When You Cross Over

SDE and EBITDA are related but serve different purposes. The key difference: SDE includes one owner's total compensation. EBITDA does not — it assumes the owner is replaced by a salaried manager.

For businesses where the owner is the operator (most businesses under $5M in value), SDE is the right metric. The buyer is buying a job and a business, and they want to know the total cash flow available to them.

For larger businesses with professional management in place, EBITDA is the right metric. A private equity buyer isn't going to run your business personally — they'll install a CEO and pay them market rate. EBITDA reflects the earnings after that management cost is accounted for.

The crossover typically happens around $1M-$2M in SDE, or roughly $5M-$10M in enterprise value. At that point, the business is large enough to support professional management, and buyers start thinking in EBITDA terms. The multiple also changes — SDE multiples for small businesses (2-4x) are lower than EBITDA multiples for larger businesses (4-8x), but that's partly because EBITDA is a smaller number (it doesn't include the owner's comp).

Why SDE Matters More Than You Think

SDE isn't just an academic number. It directly determines three things that affect your life:

Your sale price.A $50K increase in documented SDE at a 3x multiple is $150K more in your pocket at closing. That's why properly identifying and documenting add-backs is the highest-ROI activity in the entire sale preparation process.

Buyer financing.SBA lenders require that the business's SDE can cover the debt service on the acquisition loan, typically at a 1.25x coverage ratio. If your SDE is too low to support the purchase price, the buyer can't get financing and the deal dies.

Your negotiating position.A clean, well-documented SDE calculation gives you credibility. Buyers trust sellers who understand their own numbers. If you can walk a buyer through your SDE with supporting documentation for every add-back, you're signaling that you're a sophisticated seller — and sophisticated sellers get better deals.

The Bottom Line

If you're thinking about selling your business in the next few years, calculate your SDE today. Not next month. Today. It takes an hour with your tax returns and a spreadsheet. The number you get will either confirm that you're in a good position to sell, or it will reveal exactly what you need to fix before going to market.

And remember: SDE is a factual calculation, not a creative exercise. Every add-back needs to be real, documented, and defensible. The sellers who inflate their SDE with aggressive add-backs don't get higher prices — they get buyers who walk away during due diligence.