Seller's Discretionary Earnings (SDE) is the single most important number in small business acquisitions. It represents what a full-time owner-operator takes home from the business annually, including both salary and profit.
SDE Formula: Net Income (from tax returns) + Owner's Salary & Wages + Owner's Health Insurance & Benefits + Owner's Personal Expenses Run Through the Business + Depreciation & Amortization + Interest Expense + One-time / Non-recurring Expenses = Seller's Discretionary Earnings (SDE)
Why SDE matters: When you buy a small business, you're buying the right to earn the SDE. If a business has $300K SDE and sells at 3x, you're paying $900K for the right to earn $300K per year (before debt service). This is why SDE is the basis for virtually all small business valuations.
SDE vs. EBITDA: The key difference is that SDE adds back the owner's salary while EBITDA does not. SDE assumes one owner-operator will run the business. EBITDA assumes a salaried manager will be hired. For businesses under $5M revenue where the buyer will be the operator, SDE is the appropriate metric.
Common SDE adjustments (add-backs): - Owner's salary: $80K–$200K (whatever the owner pays themselves) - Owner's health insurance: $10K–$30K - Owner's car payment, cell phone, meals: $5K–$20K - Family members on payroll who won't continue: varies - One-time legal or consulting fees: varies - Above-market rent (if owner owns the building): difference vs. market rate
Red flags in SDE calculations: - Aggressive add-backs without documentation - "Cash income" that doesn't appear on tax returns - Add-backs that exceed 50% of reported net income - No supporting documentation for discretionary expenses