Valuation
What SDE is, and how to rebuild it yourself
The SDE on a listing is the seller's argument for a price. Before you agree with the argument, rebuild the number from documents you can verify.
Where the cash goes
Annual amounts in USD, before income taxes.
- Stated SDE
- $175,000
- Replacement pay
- −$60,000
- Capex reserve
- −$15,000
- Debt service
- −$72,865
- Annual cash flow
- $27,135
Fictional example: $500,000 price, $175,000 SDE, 10% down, 10.5% loan over 10 years. Change the assumptions in the calculator.
Seller's discretionary earnings is the total financial benefit one full-time owner-operator takes out of a business in a year. It starts with pre-tax profit and adds back the owner's own salary and benefits, interest, depreciation and amortization, and one-time or non-business expenses. It answers a simple question: if you owned this business and ran it yourself, how much cash would it produce before you paid any debt or yourself?
Most businesses that sell for under a few million dollars are priced as a multiple of SDE. That makes SDE the most important number in the deal, and also the easiest to inflate.
The formula
SDE = net profit before tax + owner's salary and payroll taxes + owner's benefits + interest + depreciation and amortization + legitimate one-time and personal expenses run through the business.
Larger businesses with a management team are usually valued on EBITDA instead, which does not add back a manager's salary because a buyer would still have to pay one.
A worked example
| Line | Amount |
|---|---|
| Net profit before tax (illustrative corporation accounts) | $62,000 |
| Owner's W-2 salary and payroll tax | $55,000 |
| Owner's health insurance | $14,000 |
| Interest on equipment loan | $6,000 |
| Depreciation | $21,000 |
| One-time roof repair on owned building | $9,000 |
| Owner's personal vehicle, run through the business | $8,000 |
| Stated SDE | $175,000 |
At a 3× multiple, that is a $525,000 asking price. Every $10,000 of add-backs you accept adds $30,000 to the price. That is why add-backs deserve the most scrutiny.
This example assumes the owner's compensation was deducted in the business accounts. A sole proprietor's owner draws are not W-2 wages and should not be added back as a wage expense. Match the bridge to the entity's actual tax treatment; see IRS sole proprietorship guidance. Avoid counting the same benefit twice.
Which add-backs survive
Usually fine, once documented: the owner's salary and payroll taxes, the owner's health insurance, interest, depreciation and amortization.
Fine only with evidence: a one-time expense that genuinely will not recur. A roof repair once in twenty years is one-time. Equipment repairs every year are not, no matter what the seller calls them.
Usually rejected:
- Depreciation in a capital-heavy business. Depreciation is added back, but trucks, mowers and dryers still wear out. If the business must spend $25,000 a year replacing equipment, subtract a capex reserve from SDE before valuing it. The workbench has a field for exactly this.
- Family on the payroll. If the seller's spouse does real work, someone has to be paid to replace them. Only add back the amount above a fair market wage.
- "Cash not reported." If income was not on the tax return, a lender will not count it, and you are being asked to pay for income the seller would not stand behind.
- Expected savings. Cost cuts you could make belong to you, not the seller. Do not pay for your own future work.
How to rebuild it
- Get three years of tax returns and the year-to-date profit and loss statement. Lenders use the returns. So should you.
- Reconcile revenue to bank deposits. Twelve months of statements should roughly match reported revenue. Big gaps in either direction need an explanation.
- List every add-back with a document. A receipt, an invoice or a ledger entry. No document, no add-back.
- Apply replacement compensation and a capex reserve. If you will hire a manager, subtract their full cost.
- Look at the trend, not the average. Three years at $150,000, $175,000 and $200,000 is a different business from $200,000, $175,000 and $150,000.
When to bring in an accountant
For a deal large enough to justify it, a quality of earnings review by an independent accountant tests revenue, expenses and add-backs in far more depth. It costs money. It costs much less than overpaying for earnings that are not there.