Seller’s Discretionary Earnings (SDE) Explained for Florida Business Owners

If you’ve started researching what your business is worth, you’ve probably come across the term Seller’s Discretionary Earnings, commonly abbreviated as SDE. It’s one of the most important concepts in small business valuation, and understanding it can give you a significant advantage when it comes time to sell.

Let’s break it down in plain language.

What Is SDE?

Seller’s Discretionary Earnings is a measure of the total financial benefit an owner-operator receives from running a business each year. It’s calculated by taking your net profit and adding back certain expenses that reduce your taxable income but don’t represent real ongoing costs to a future buyer.

In other words, SDE is the answer to this question: “If I buy this business and run it myself full-time, how much money will it put in my pocket each year?”

How Is SDE Calculated?

Start with your net profit (after all expenses), then add back:

• Owner’s salary and benefits: What you pay yourself, including health insurance, retirement contributions, and any other owner-specific compensation
• Personal expenses run through the business: Vehicle expenses, phone bills, certain meals, travel, or other costs that are for your personal benefit and wouldn’t continue under new ownership
• Depreciation and amortization: These are non-cash accounting expenses that don’t represent actual money leaving the business
• Interest expense: Financing costs that are specific to your current debt structure and won’t carry over to the buyer
• One-time or non-recurring expenses: Costs that happened in a particular year but won’t repeat (major repairs, legal fees for a one-time issue, startup costs)

The sum of all these additions gives you your SDE, and it’s almost always significantly higher than the net profit shown on your tax return.

A Simple Example

Let’s say you own an HVAC service company in Northeast Florida. Here’s how its SDE is built, step by step:

• Start with net profit as reported on the tax return
• Add: Owner salary (paid through payroll in an S corporation) and the employer payroll taxes on it
• Add: Owner health insurance
• Add: Documented personal vehicle expenses
• Add: Depreciation
• Add: A documented one-time equipment repair
• The total is SDE

That total is usually well above the reported net profit, and it’s the number a buyer will use to evaluate what your business is worth.

Recasting: How Your Tax Return Becomes SDE

Recasting, also called normalizing, is the work of turning the profit on your tax return into SDE. Your return is built to keep taxes low, which is legal and normal. A buyer needs to see what the business earns for one full-time owner, so every legitimate add-back has to be identified, explained, and backed up.

I prepare a recast for every seller before a business goes to market, because buyers, their CPAs, and their lenders will rebuild your numbers on their own. A recast never changes your filed returns; it explains them, and your CPA should review it before it goes to a buyer.

Normalizing Works in Both Directions

Most owners only think about add-backs, but a recast also subtracts costs a buyer will face that you don’t carry today:

• Related-party rent: if you lease the building from your own real estate entity, rent is adjusted to market. Rent above market is added back; rent below market is deducted, because the buyer will sign a real lease.
• Family payroll: a relative paid more than the job is worth creates an add-back for the difference. A spouse or child who works for little or nothing creates a deduction for the cost of replacing them.
• A second job you do: SDE assumes one owner. If you also work full time as the bookkeeper or lead technician, the cost of hiring for that second role comes out.

Build an Add-Back Schedule You Can Defend

Every adjustment belongs on a schedule that shows the year, the amount, what it was, and where the proof is: general ledger detail, an invoice or receipt, a bank or card statement, and the tax return line it sits in. A personal expense should be one the business won’t need to keep running. A one-time expense shouldn’t show up again the next year.

Two kinds of add-backs rarely survive. The first is cash sales that never made it into the books, because buyers and lenders can only rely on income you reported. The second is a “one-time” cost that appears every year.

What Buyers and SBA Lenders Accept

Many buyers finance with an SBA 7(a) loan, and SBA rules shape how your add-backs are treated. Under the SBA’s current lending procedures (SOP 50 10 8.1), the lender:

• Verifies the business’s tax returns against IRS tax transcripts, so the starting point is always the return you filed
• Must justify each adjustment or add-back in its credit memo, and adjustments without that supporting analysis don’t count toward the loan’s cash flow test
• Relies on a business valuation prepared for the lender, not one prepared for you or the buyer, and checks the financial data behind it against your IRS transcripts
• On larger acquisitions, also requires a quality of earnings report that reconciles bank statements to the income statement and tax returns

Source: U.S. Small Business Administration, including its 7(a) loan program page and its SOP 50 10 lending rules. SBA rules change, so verify current requirements with the SBA or an SBA lender before relying on them.

The same rules require the buyer’s own pay to cover their living expenses, so lenders account for a salary the new owner can live on before deciding whether the business can carry the debt. An add-back the lender rejects shrinks the loan a buyer can get, and that usually shows up in the price.

If your books need work first, start with my guide to cleaning up your financials before a sale, and read how a quality of earnings report works if your deal is headed that way.

Where Your Pay Shows Up Depends on Your Entity

Owner pay is usually the biggest add-back, but where it sits on your return depends on how the business is set up. Getting this wrong is an easy way to overstate SDE.

Sole Proprietors and Single-Member LLCs Filing Schedule C

On a Schedule C you can’t deduct pay to yourself as wages, and your own health insurance and retirement contributions are deducted on your personal return, not on Schedule C. That means your Schedule C net profit already includes your compensation. There’s no owner salary to add back, and adding one anyway counts the same dollars twice.

S Corporations

An S corporation has to pay a working shareholder reasonable compensation as wages before taking distributions, and those wages are an expense on the corporate return. Your wages, the employer’s share of payroll taxes on them, and health insurance the company pays for you are the usual add-backs. Distributions are not an expense, so they’re already inside the profit and never get added back.

Partnerships and Multi-Member LLCs

Partners aren’t paid wages. A working partner’s fixed payments for services are guaranteed payments, which the partnership deducts as a business expense, so the working owner’s guaranteed payments are added back the way a salary would be.

Two Working Owners, One Add-Back

SDE assumes one full-time owner. If you and a partner both work in the business, only one owner’s pay is added back. The other role stays in as an expense at what it would cost to hire someone for that job, because one buyer can’t do both.

How SDE Is Used in Valuation

Buyers and lenders look at SDE together with what makes it more or less reliable: how steady it has been over three years, how much depends on you, customer concentration, the lease, and the condition of equipment. Two businesses with the same SDE can sell for very different prices for those reasons.

Why This Number Matters

SDE is the foundation of any business valuation for a small to mid-sized company. Getting it wrong, either too low or too high, leads to problems. Too low, and you leave money on the table. Too high, and buyers (or their lenders) can’t verify the number and the deal falls through.

That’s why it’s important to work with a professional who can help you accurately calculate your SDE and build a well-documented add-back schedule that buyers and lenders can verify.

Why the Trend Matters as Much as the Number

Buyers don’t price off one good year. Show SDE for each of the last three years and the trailing twelve months side by side, because that’s how buyers and their lenders will read it. If the most recent year is lower, have the reason documented before anyone asks.

SBA lenders make the trend concrete. Under SOP 50 10 8.1, the lender tests whether the business can cover the buyer’s debt using recent historical results, and it can’t rely on the buyer’s projections to pass that test. A strong year further back won’t carry a weak last year. My article on how SBA loans affect your sale covers the rest of the lender’s review.

Depreciation Isn’t Free Money

Depreciation is added back because it’s a non-cash expense, but equipment still wears out. If trucks, ovens, or machines will need replacing soon, expect buyers to account for that cost; SBA rules list unfunded capital expenditures among the cash flow adjustments a lender can make. A record of maintenance and replacements helps that add-back hold up.

If you’d rather hear it explained, watch my video on SDE and add-backs.

Frequently Asked Questions

What is the difference between SDE and EBITDA?

SDE adds back the full pay and benefits of one working owner, so it fits businesses where the buyer will run the company day to day. EBITDA assumes a paid manager is already in place and does not add back that salary, which is why it is used more for larger companies. Which measure fits depends on who the likely buyer is.

Can I add back cash income I didn't report?

No. Buyers rely on the income you reported, and SBA lenders verify tax returns against IRS transcripts. If you want credit for revenue when you sell, it needs to be on your books and your returns, ideally for several years before you list.

How many years of financials will buyers review?

Plan on at least three years of tax returns and profit and loss statements, plus the current year to date. SBA lenders base their analysis on the most recent year-end statements and compare the latest interim period with the same period a year earlier.

Are S corporation distributions added back to SDE?

No. Distributions aren’t an expense on an S corporation’s return, so they’re already included in the profit you start from. The owner’s wages, the employer payroll taxes on them, and owner benefits the company pays are the add-backs. Adding back distributions would count the same money twice.

I file a Schedule C. Do I add back my owner draws?

No. Draws aren’t deducted on Schedule C, so your net profit already includes them. You can still add back documented personal expenses, depreciation, interest, and true one-time costs that ran through the business.

Does SDE account for the buyer's loan payments?

No. SDE is measured before any acquisition debt, because every buyer finances the purchase differently. Buyers and lenders subtract the new loan payments and a living salary for the new owner to see whether the deal works, which is why a well-supported SDE matters for financing.

Find Out Your SDE Estimate

Curious what your SDE might look like? Start with my free business valuation calculator for a realistic estimate of your business’s market value. Or request a free, confidential valuation or call (904) 789-1276, and we can walk through your actual numbers together.

• Category: Business Valuation