When evaluating the financial performance of a small business, one of the most critical metrics used by business buyers, brokers, and lenders is Seller’s Discretionary Earnings (SDE). But what exactly is SDE, why does it matter, and how is it calculated?
SDE is particularly important in small business transactions, where the owner’s involvement is deeply tied to the company’s operations and profitability. Unlike EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which is more common in middle-market and larger company valuations, SDE includes the owner’s salary and certain discretionary expenses.
SDE is crucial for both buyers and sellers:
Buyers want to understand how much income they can expect to earn from the business if they replace the owner and operate it themselves.
Sellers use SDE to justify their asking price and demonstrate the business’s earning potential.
Lenders, particularly SBA lenders, also use SDE to determine whether the business generates enough cash flow to cover debt payments after acquisition.
SDE starts with net income (the “bottom line” from the tax return or P&L statement), and then adds back certain expenses that are not essential to the business or are considered “discretionary.” These typically include:
Owner’s Salary or Compensation
Payroll Taxes on the Owner's Wages
Owner’s Perks or Discretionary Expenses
Personal vehicle expenses
Travel not essential to business
Meals and entertainment
Health insurance for the owner
Non-Cash Expenses
Depreciation and amortization
One-Time or Non-Recurring Expenses
Legal fees for a lawsuit
Unusual repairs or equipment purchases
Interest Expense
Since buyers will bring their own capital or debt structure
SDE = Net Profit + Owner’s Salary + Interest + Depreciation + Amortization + Discretionary and Non-Recurring Expenses
Suppose a business has the following:
Net Profit: $100,000
Owner’s Salary: $75,000
Depreciation: $10,000
Interest: $5,000
One-Time Legal Fees: $7,000
Personal Car Expenses Run Through the Business: $3,000
SDE = $100,000 + $75,000 + $10,000 + $5,000 + $7,000 + $3,000 = $200,000
This $200,000 is the total earnings available to a new owner-operator.
Including normal business expenses as add-backs (only discretionary or non-essential ones should be added back)
Most small businesses (under $5 million in revenue) are valued based on a multiple of SDE, depending on the industry, size, risk, growth potential, and other factors. For example:
A business with $200,000 in SDE might sell for 2.5x – 3.0x SDE, or $500,000 to $600,000.
The cleaner and more justifiable the SDE calculation, the easier it is to attract serious buyers and close a deal.
Understanding and accurately calculating Seller’s Discretionary Earnings is essential when preparing to sell or buy a small business. It not only helps determine valuation but also gives both parties a realistic view of the business’s earning potential. At EDGE Business Advisors, we work with business owners and buyers to ensure SDE is clearly presented and properly analyzed, so informed decisions can be made and transactions close with confidence.
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