What is SDE, and why does the seller’s number never match yours?

The one-sentence version

Seller's Discretionary Earnings is the total financial benefit one full-time owner-operator gets from a business in a year, before tax and before any debt used to buy it.

That definition is doing a lot of work, and almost every dispute in a small-business acquisition lives inside it.

How it is built

Start at the bottom of the profit and loss statement and work upward:

Net income — what the business reported as profit.

+ Interest — because the seller's loans do not transfer to you in an asset sale. You will have your own.

+ Taxes — because tax depends on the owner's structure and circumstances, not on the business.

+ Depreciation and amortization — non-cash charges. Nothing left the bank account.

That gets you to EBITDA: earnings before interest, taxes, depreciation and amortization. For a business large enough to pay a professional manager, EBITDA is where the analysis stops.

Small businesses are different, because the owner is usually working in the business. So:

+ Owner's compensation — salary and the employer's share of payroll taxes.

+ Genuinely discretionary expenses — personal costs run through the business that a new owner would simply not incur.

+ True one-time items — a lawsuit settled once, a rebrand, a flood.

That total is SDE.

Why it exists at all

Two identical businesses can report wildly different net income depending on how aggressively the owner pays themselves and how much personal spending flows through the company. SDE strips that out so you can compare them. Used honestly it is a good idea.

Used dishonestly, it is the single easiest place to inflate a business.

What legitimately belongs in SDE

• The owner's salary and payroll burden, at any amount.
• Health insurance and retirement contributions for the owner and their family.
• Personal vehicle costs, if the vehicle is genuinely personal and the business does not need it.
• Personal travel, meals and entertainment booked to the company.
• Non-cash depreciation and amortization.
• Interest on debt that will not transfer to you.
• Rent above market paid to a related party, adjusted to the market rate.
• Costs that genuinely occurred once and will not recur.

What does not

This is where reports get interesting.

A salary paid to a family member who does real work. If somebody is doing a job, you will have to pay somebody to do that job. It is a cost, not a perk.

A "consulting fee" that appears every single year. Recurrence is the test. An expense that shows up in three consecutive tax returns at the same amount is an operating cost wearing a costume.

A vehicle the business needs. If deliveries happen, the delivery vehicle is not discretionary.

Deferred maintenance. Not spending money you should have spent is not profit. It is a bill you inherit.

One-time costs that happen every year. Businesses always have a one-time cost. Last year's flood, this year's lawsuit, next year's equipment failure. Individually one-time; collectively, a run rate.

Below-market rent from a related party. If the seller owns the building and charges the business half of market rent, the SDE is inflated by the difference — and your rent, once the building is sold or the lease renegotiated, will be the market rate.

Why the seller's number and the documented number differ

Because SDE is a constructed figure, not a reported one. It appears on no tax return and no financial statement. Somebody built it, and how carefully they built it is the whole question.

In practice you will see three things:

1. 1.Add-backs with no paperwork. The seller says $12,000 of travel was personal. There is no itinerary, no invoice, no way to check. Until there is, that $12,000 is not earnings.

1. 1.Costs reclassified as discretionary. The family salary. The consulting fee. The vehicle. Each defensible in isolation, and together often a quarter of the stated SDE.

1. 1.Owner labour not charged for. The listing says the owner works fifteen hours a week. The payroll register shows staffing costs at 7% of revenue in an industry where 15% is normal. Both cannot be true.

That third one is the most consequential, because it decides whether you are buying a business or a job.

The test that settles it

For every add-back, ask two questions:

Can you show me? A document, a page, an invoice. Not an explanation.

Will it really stop? Would a new owner, running this business competently, genuinely not incur this cost?

An add-back that fails either test does not belong in the number you value the business on. It might still be true — but you do not pay a multiple on things that might be true.

What to do with the answer

Once you have documented SDE, everything downstream follows: the multiple, the valuation range, what a lender will finance, and whether the deal supports both a loan and a living.

And if the documented figure comes in well below the advertised one, you have not lost anything. You have found the negotiation. The gap between the two numbers, multiplied by the category multiple, is exactly how much the price should move — and unlike most negotiating positions, it is arithmetic rather than opinion.