How to Calculate Seller Discretionary Earnings (And Why the Number on the Listing Is Wrong)

Every small business listing has a number on it. Usually it says something like "SDE: $420,000" or "Owner Earnings: $380,000." That number is how the asking price gets justified. A business asking $1.4M at 3.3x SDE sounds reasonable if the SDE is real.

Here's the problem: that number is the seller's version.

The seller, with help from their broker, calculated that number in the way that makes the business look as valuable as possible. Some of those calculations are legitimate. Some are aggressive. A few are wrong. And you won't know which is which until you reconstruct the number yourself.

This is not a cynical observation. It's just how the process works. The seller is making an argument that the business earns X. Your job is to make your own argument. The gap between the two numbers is where the negotiation happens.

This guide walks you through how to do that.

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What SDE actually is

Seller Discretionary Earnings is the total financial benefit a full-time owner-operator receives from the business in a given year. It's designed to answer one question: if you bought this business and ran it yourself, how much money would you make?

It's different from net income because net income is calculated after the owner's salary, which is arbitrary. An owner can pay themselves $50K or $300K. Net income changes. SDE doesn't, because you add the salary back.

It's different from EBITDA because EBITDA is designed for larger businesses with professional management teams. EBITDA assumes the business already has a management layer in place. SDE assumes the owner is the management layer. For small businesses under $5M in revenue, SDE is the right metric.

The formula is:

SDE = Net Income + Owner Salary + Owner Benefits + Non-Cash Expenses + Non-Recurring Expenses + Interest

Each of those additions is called an "add-back." The add-backs are where the arguments happen.

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A worked example

Let's use a real-looking set of numbers. Landscaping company, $1.2M in revenue.

The seller's tax return shows:

Line item	Amount
Revenue	$1,200,000
Cost of goods sold	$480,000
Gross profit	$720,000
Operating expenses	$540,000
Net income	$180,000

The seller's broker presents an SDE calculation like this:

Add-back	Amount
Net income	$180,000
Owner salary	$120,000
Owner health insurance	$18,000
Owner vehicle (personal use)	$12,000
One-time legal expense	$25,000
Depreciation	$35,000
Interest expense	$15,000
Total SDE	$405,000

At a 3.3x multiple, that's a $1.34M asking price. Seems reasonable for a $1.2M revenue business.

Now let's look at each add-back.

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Which add-backs are legitimate

Owner salary ($120,000). Legitimate. The owner was paying themselves a salary that reduced net income. Since you'd pay yourself too, you add it back. But there's a catch we'll get to in a moment.

Owner health insurance ($18,000). Legitimate. This is a real benefit the owner received through the business. You'd receive it too.

Depreciation ($35,000). Legitimate. Depreciation is a non-cash accounting expense. The business didn't actually spend $35K in cash. Adding it back gives you a cleaner picture of cash earnings.

Interest expense ($15,000). Legitimate. This reflects the seller's financing, not yours. You'll have different debt with different terms. Adding it back lets you evaluate the business independent of how it's currently financed.

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Which add-backs deserve scrutiny

Owner vehicle ($12,000). Ask for documentation. Is this vehicle used exclusively for personal purposes, or does it also serve the business? If the owner drives it to job sites, it's a business expense, not a personal one. Adding it back would inflate SDE.

One-time legal expense ($25,000). This is the most common place sellers inflate SDE. "One-time" means it won't happen again. Ask for the details. What was the lawsuit about? Has the company had other legal expenses in the past three years? If there's a pattern of legal costs, they're not one-time. They're a cost of doing business.

There are really only three games sellers play with add-backs, and once you know them, you can spot them in 20 minutes. First: the owner salary is set below market, so the add-back looks larger than it is, but you'd have to pay a replacement manager more than the seller paid themselves. Second: recurring costs get labeled "one-time." Third: personal expenses that are also genuinely necessary for the business to function get added back as if they're pure personal benefit. The third one is the hardest to argue because the seller isn't wrong - they just aren't telling you the full story.

Owner salary ($120,000) revisited. Here's the catch. The owner salary add-back assumes you're going to run the business yourself. If you are, the add-back is legitimate. If you're planning to hire a general manager to run it while you stay in your current job, you need to subtract the cost of that manager from the add-back. If a competent GM costs $80K, your effective add-back is $40K, not $120K. That changes the SDE from $405K to $325K. At 3.3x, that's a $1.07M business, not a $1.34M business.

This is the single most common mistake buyers make when evaluating SDE.

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How to reconstruct it yourself

Don't rely on the seller's SDE calculation. Build your own from the source documents.

Step 1: Get three years of tax returns. Not the P&L the broker prepared. The actual tax returns. Tax returns are harder to manipulate than internal financials because they were filed with the IRS. Look at all three years, not just the most recent one.

Step 2: Start with net income from the tax return. This is your baseline. If the net income on the tax return is significantly different from the net income on the broker's P&L, ask why.

Step 3: Add back only what you can verify. For each add-back the seller claims, ask for documentation. Owner salary: show me the W-2. Health insurance: show me the premium statements. One-time expenses: show me the invoice and explain why it won't recur.

Step 4: Adjust for your situation. If you're not going to run the business yourself, reduce the owner salary add-back by the cost of the manager you'd hire. If the business needs capital investment that the seller has been deferring, subtract that from your SDE estimate.

Step 5: Average across three years. A single year of SDE can be misleading. Average the last three years to get a more stable picture. If SDE has been declining, weight the recent years more heavily. If it's been growing, understand why before you assume the growth will continue.

But don't just average. Look at the trend. A business with SDE of $300K, $350K, $400K over three years is a very different business from one with $400K, $350K, $300K, even though the three-year average is the same. The declining business is worth less, and the seller knows it. That's often why they're selling now.

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SDE vs EBITDA

You'll see both terms used in small business acquisitions. Here's when each applies.

SDE is the right metric for businesses under roughly $2M in SDE where the owner is actively involved in operations. It captures the full economic benefit to an owner-operator.

EBITDA is the right metric for larger businesses with professional management teams already in place. It measures earnings before the owner's compensation because the owner isn't running the business day-to-day.

If you're looking at a business where the owner works in it full-time and the asking price is under $5M, use SDE. If you're looking at a business with a management team and the asking price is above $5M, EBITDA becomes more relevant.

Some brokers use EBITDA for smaller businesses to make the multiple look lower. A business with $400K in SDE and a $120K owner salary has $280K in EBITDA. At 3.3x SDE, the asking price is $1.32M. At 4.7x EBITDA, it's the same $1.32M. Same price, different framing. Know which metric you're looking at.

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When your number is different from the seller's

It will be. That's normal.

The question is how different, and why. A 5 to 10% difference is usually a matter of interpretation on specific add-backs. A 20 to 30% difference means you and the seller have fundamentally different views of what the business earns.

When you find a significant gap, don't argue about the add-backs in the abstract. Go back to the source documents. "Your SDE calculation includes a $25K one-time legal expense. I found two similar expenses in the prior three years. I'm treating this as a recurring cost, which reduces my SDE estimate to $360K. At 3.3x, I'm at $1.19M, not $1.34M."

That's a negotiation, not a dispute. You're not saying the seller is wrong. You're saying you see the numbers differently, and here's why.

Most sellers expect this. The ones who don't are the ones worth being cautious about.

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The short version

SDE is not a fact. It's an argument. The seller makes one argument. You make another. The truth is somewhere in between, and the only way to find it is to build the number yourself from the source documents.

The formula is simple. The judgment calls are not. The most important one: if you're not running the business yourself, the owner salary add-back is not what the seller says it is.

Get the tax returns. Verify every add-back. Adjust for your situation. Average across three years.

That's how you know what you're actually buying.

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AcquiPilot walks you through SDE reconstruction and deal stress testing as part of the deal evaluation workflow. Start for free.