Seller's Discretionary Earnings (SDE)

Seller's discretionary earnings is the annual pretax financial benefit a business produced for one owner-operator, computed by taking the business's earnings and adding back the items that reflect that owner's choices rather than the business's operating economics. The International Business Brokers Association, whose glossary states its purpose as standardizing the vernacular for the business brokerage profession, defines the measure as "the earnings of a business enterprise prior to the following items: income taxes, non-operating income and expenses, nonrecurring income and expenses, depreciation and amortization, interest expense or income, one owner's entire compensation, including benefits and any non-business or personal expenses paid by the business."

Several names describe the same computation, and IBBA treats them as equivalent. Its own headword is the shorter "Discretionary Earnings (DE)"; "Seller's Discretionary Earnings (SDE)", "Seller's Discretionary Cash Flow (SDCF)", "Adjusted Net" and "Owner Benefit" all appear in its glossary as cross-references to that one entry. The longer form is used here because bare "discretionary earnings" reads as a category rather than a metric. The AICPA's Journal of Accountancy describes the same measure from the practitioner side, as "EBITDA plus owner's compensation and benefits and other discretionary expenses, or 'add-backs'", and notes that it "attempts to define the recent historical annual pretax benefit that a seller has derived from the practice on a cash basis."

Why the measure exists at all. A business with one working owner reports a profit that says more about the owner's tax planning than about the business. The same operation can show a $30,000 profit while paying the owner $200,000 in salary, or a $200,000 profit while paying $30,000, and nothing about the underlying operation has changed. A buyer is not buying the profit line; they are buying the total benefit the business can deliver to one person who will both own it and work in it. Seller's discretionary earnings is an attempt to state that total in one number.

The one-owner rule is the element most often stated wrongly, and it runs in both directions. IBBA adds back "one owner's entire compensation," not every owner's. Its separate entry for the quantity being added back makes the asymmetry explicit: Owner Total Compensation is the "total of an owner's salary and perquisites, after the compensation of all other owners has been adjusted to market value." So a two-owner business adds back the working owner's whole package and then restates every other owner's pay at market. Where a second owner has been drawing less than a market wage for real work, that restatement is a subtraction, and the resulting figure is lower than the naive add-everything-back version. A page or a broker's package that adds back all owners' pay is describing a business that will need to hire replacements the buyer has not been told about.

What counts as a discretionary or nonrecurring add-back, and where the argument happens. The uncontroversial items are mechanical: interest, income taxes, depreciation, amortization. The contested ones are the judgment calls, and they are where a seller's number and a buyer's number diverge:

• Owner perquisites run through the business. A vehicle, a phone, travel with a personal component, family members on payroll for work the buyer would not need done.
• Nonrecurring items. A one-time legal settlement, a flood repair, a single large bad debt. Each is a legitimate add-back if it genuinely will not recur, and each is a place to inflate the number if it will.
• Discretionary spending the buyer might not continue: charitable contributions, a conference the owner enjoys, above-market rent paid to an entity the owner also owns.
• Expenses the buyer will actually incur. This is the trap in reverse. If the seller works sixty hours a week and the buyer intends to hire a manager, the manager's salary is a real future cost, and adding back the seller's pay without noting the replacement cost overstates what the buyer will earn.

How a multiple gets applied, and what it does not mean. Small businesses are commonly priced at some multiple of this figure. The multiple is a market observation, not a rule, and it moves with the industry, the size of the business, how concentrated its customers are, how transferable the owner's role is, and credit conditions at the time. Two consequences follow. First, every dollar added back is a dollar multiplied, so an aggressive add-back list is worth several times its own size to the seller, which is why the add-back schedule is negotiated rather than calculated. Second, a multiple applied to a number computed on different conventions than the multiple was derived from produces a meaningless answer.

Where it sits among the other measures. Earnings before interest, taxes, depreciation and amortization is the same idea without the owner-compensation add-back, which is why it is the measure used for businesses large enough to have professional management already priced into the expenses. A larger business is usually quoted on earnings before interest, taxes, depreciation and amortization; a smaller owner-operated one on seller's discretionary earnings. Neither is a cash flow statement figure and neither accounts for what the business must spend on equipment to keep running, so a capital-intensive business can carry a healthy figure and very little money available to a new owner after replacing assets.

1. Start from the business's earnings before income taxes, taken from the profit and loss statement.
2. Add back interest and the non-cash charges, meaning depreciation and amortization. These reflect financing and past asset purchases rather than current operations, and a buyer will finance the business their own way.
3. Add back one owner's entire compensation package: salary, payroll taxes on it, benefits, and any personal expenses paid by the business.
4. Adjust every other owner's compensation to market value. Where another owner is underpaid for real work, this reduces the figure; where an owner is paid for work the business does not need, it increases it.
5. Add or remove non-operating and nonrecurring items so what remains describes a normal year of the business as it will actually be run.
6. State the conventions you used, because the number is only comparable to another number computed the same way.

A hypothetical shows why step 4 matters. Terrace Grounds is a landscaping company with two owners. Dana runs it full time; Rafael handles the books a few hours a week and is paid $40,000, for work a bookkeeping firm would charge about $70,000 a year to do at the volume the business needs. Last year the company reported:

• Net income before income taxes: $118,000
• Interest expense on an equipment loan: $9,000
• Depreciation and amortization: $27,000
• Dana's salary $95,000, health insurance $14,000, and personal vehicle costs run through the business $6,000, so $115,000 in total compensation
• A one-time legal settlement over a fence dispute: $12,000

Seller's discretionary earnings is $118,000 + $9,000 + $27,000 + $115,000 + $12,000, less the $30,000 needed to bring Rafael's pay up to market, which comes to $251,000. The employer's payroll taxes on Dana's salary belong in the add-back too, since IBBA's definition of an owner's salary includes "related payroll burden"; they are left out of the arithmetic here to keep it legible.

Two things a buyer should notice about that figure. The $12,000 settlement is only a legitimate add-back if the dispute is genuinely over. And $251,000 is what the business delivered to one full-time owner-operator, so a buyer who plans to hire a manager rather than run the crews personally has to subtract that manager's pay before comparing the number to a salary they would give up.

Pros

• Makes owner-operated businesses comparable to each other, which reported profit cannot do, because reported profit depends mostly on how the owner elected to be paid.
• States the whole benefit a buyer could receive in one number, including the salary they would draw, rather than splitting it between wages and profit.
• Has a published definition from the body that standardizes the vocabulary of business brokerage, so a buyer and a seller can at least argue about the same computation.
• Forces the personal expenses inside a business into the open, which is frequently the first time an owner sees what the business is actually paying for on their behalf.

Cons

• No government or accounting standards body defines it, so there is no authority to appeal to when a buyer and seller disagree about an add-back.
• Every add-back is multiplied when a multiple is applied, so the incentive to stretch the list is several times the size of the item itself.
• It ignores what the business must spend to keep operating. A business needing a $60,000 truck every four years and one needing a laptop can report the same figure and hand a buyer very different amounts of spendable cash.
• It assumes one owner-operator. A buyer who will not work in the business full time has to deduct the cost of the people who will, and the seller's package rarely does that arithmetic for them.
• It is a pretax figure computed largely on cash conventions, so it is neither the taxable income the buyer will report nor the cash the business will generate.