Understanding Seller’s Discretionary Earnings (SDE): Why It Confuses So Many First-Time and International Buyers

The Business Makes $400,000… So Why Does the Tax Return Show Only $50,000?

One of the biggest surprises for first-time buyers is discovering that the profit shown on a company’s tax return is often very different from the earnings a business broker advertises.

This difference is usually explained by a concept called Seller’s Discretionary Earnings, commonly referred to as SDE.

Over the years, we have found that SDE is one of the most misunderstood concepts in business acquisitions. It can be confusing for American buyers purchasing their first business, but it is often even more perplexing for overseas buyers, particularly those from France and other European countries where accounting rules tend to be much stricter.

Let’s look at why.

Net Income Is Not the Same as SDE

Many buyers naturally assume that if a business shows a net income of $50,000 on its tax return, then the owner only made $50,000.

Not necessarily.

The purpose of SDE is not to show what the business earned after the owner’s lifestyle choices and discretionary spending. Instead, SDE attempts to answer a different question:

How much cash flow would have been available to a single owner-operator had the business not paid for certain discretionary expenses?

In other words, SDE reconstructs the earnings of the business by adding back expenses that are either:

• specific to the current owner,

• non-recurring,

• financing related, or

• non-cash accounting expenses.

The result is often much higher than the net income shown on the tax return.

Why French Buyers Are Often Surprised

We frequently work with buyers from France seeking an E-2 visa through the acquisition of a business in Florida.

Many of them are initially skeptical when they see large SDE add-backs.

And frankly, their reaction makes sense.

French accounting practices are generally more rigid than those of small businesses in the United States. For example, if an invoice is issued by mistake in France, it usually cannot simply be deleted. Instead, a corresponding credit note must be issued, and both documents remain permanently in the accounting records.

In contrast, many accounting programs commonly used by small American businesses allow users to go back months or years and simply delete or modify an entry.

Likewise, certain French companies must have their financial statements reviewed and certified by a Commissaire aux Comptes, a specially licensed independent auditor whose role extends well beyond that of a typical American CPA.

The result is a very different accounting culture.

French buyers often expect the tax return to tell the entire story.

American small businesses often tell a more complicated one.

The Main Categories of SDE Add-Backs

1. Interest Expense

Interest expense is added back because it reflects how the business was financed, not how profitable it is.

One owner may have financed equipment with loans.

Another may have paid cash.

A third buyer may obtain SBA financing.

The operating performance of the business is the same regardless of financing choices, which is why interest is excluded from SDE.

2. Depreciation and Amortization

Depreciation is an accounting expense.

No cash actually leaves the business when depreciation is recorded.

The owner may have purchased equipment years ago, yet the accountant continues to depreciate it over time.

Because depreciation does not represent a current cash expense, it is added back.

3. Owner Salary and Payroll Taxes

This is one of the largest and most common add-backs.

Suppose the owner pays himself:

• $120,000 salary

• $9,000 employer payroll taxes

• $15,000 health insurance

These amounts are legitimate expenses on the tax return.

However, SDE assumes a single owner-operator purchasing the business. The owner’s compensation is therefore added back because the buyer will decide for himself how much salary to take.

But here is where confusion often arises.

Owner draws are not wages.

A distribution of profits to the owner is not an expense of the business. It has already been excluded from net income.

Therefore, it cannot be added back.

We often see sellers mistakenly listing owner draws as SDE add-backs.

They are not.

Adding them back would amount to counting the same money twice.

4. Owner Perks

Many owners run more or less legitimate personal expenses through their business.

Examples include:

• Personal medical insurance

• Company vehicle

• Personal cell phones

• Family travel

• Club memberships

• Meals and entertainment

• Internet at home

• Personal computers

• Fuel expenses unrelated to business

• Children’s phones

• Personal subscriptions

• Season tickets to sporting events

If these expenses are not necessary to operate the business, they may qualify as add-backs.

However, every item should be documented and justified.

A Real Example We Encountered

One of the most striking examples we encountered involved a small business in Central Florida.

The company owned a private airplane.

The aircraft was not used for business development.

It was not required for operations.

It was simply a hobby and a source of enjoyment for the owner.

The airplane was not included in the sale.

Yet the business paid for:

• hangar fees,

• insurance,

• maintenance,

• annual inspections,

• fuel,

• repairs, and

• depreciation.

On paper, the company appeared barely profitable.

After adding back all aircraft-related expenses, however, the business generated a very healthy SDE and became an attractive acquisition opportunity.

This is precisely why buyers must understand SDE.

The goal is not to disguise poor performance.

It is to separate the economics of the business from the personal choices of its owner.

Not Every Add-Back Is Legitimate

Unfortunately, not all add-backs are created equal.

We occasionally see sellers attempting to add back expenses that are clearly necessary for the business.

Examples of questionable add-backs include:

• The salary of an office manager who still needs to be replaced

• Advertising expenses that are required to maintain revenue

• Payroll taxes on employees who remain with the company

• Rent simply because the seller believes it is above market

• Recurring repairs and maintenance

• Inventory shortages

• Regular legal or accounting fees

If an expense will continue after the sale, it generally should not be added back.

This is why buyers should always review financial statements carefully and ask for supporting documentation.

An experienced business broker, CPA, and lender can help determine whether an adjustment is reasonable.

Add-Backs Buyers May Accept, But Lenders May Not

One important point we always emphasize is that not every add-back that makes sense to an educated buyer will be accepted by a lender or included in an SBA transaction.

In our own underwriting and due diligence, we look at a business from two different angles: what a strategic or financial buyer may consider reasonable, and what an SBA lender will actually allow when determining loan eligibility and debt service coverage. Those are not always the same.

Certain discretionary expenses may improve the buyer’s view of cash flow, but if they are not fully documented, not recurring in nature, or not accepted under lender guidelines, they may be excluded from an SBA analysis.

This is why we always encourage buyers to distinguish between adjusted SDE for valuation purposes and SBA-qualifying cash flow for financing purposes.

A number may look attractive in a broker’s presentation, but that does not mean the same number will support a loan.

Normalizing Compensation for Family Members and Related Parties

We also frequently encounter businesses where a spouse, family member, or other shareholder works in the company.

In some cases, that person is paid above market compensation. In other cases, below market compensation.

Because SDE is intended to reflect the economics of a single owner-operator, we always normalize those amounts to what we believe the business would reasonably have paid in the marketplace for that role.

That means if compensation is above market, we may add back the excess.

If it is below market, we may increase the expense to reflect a more realistic replacement cost.

Our goal is not to make the business look better or worse than it is, but to present a more accurate picture of what a buyer would actually face after closing.

Adjusting Rent for Seller-Owned Real Estate

The same principle applies when the seller owns the real estate.

In those situations, we always adjust historical SDE to reflect what a buyer would likely have paid in rent if the seller had not owned the property.

If the rent paid by the business was above market, we may normalize it downward.

If the rent was below market, we may adjust it upward.

Either way, our analysis is based on market rent, not the seller’s internal ownership structure.

This too helps us present a more realistic view of the business’s ongoing operating costs and the cash flow a buyer can actually expect.

What SDE Is — and What It Is Not

This may be the most important point of all.

SDE is not a prediction of future profits.

It is not a guarantee that the buyer will earn that amount.

And it is not the amount that will remain after debt payments.

SDE simply estimates what the business would have generated historically if the owner had not incurred certain discretionary expenses.

That cash flow would have been available to the buyer to:

• pay acquisition debt,

• pay himself a salary,

• earn a return on his investment,

• hire additional staff,

• or even transform the business into a semi-absentee or absentee ownership model.

In other words, SDE is not the buyer’s future paycheck.

It is the pool of cash flow from which the buyer can make business decisions.

Final Thoughts

Seller’s Discretionary Earnings is one of the most powerful tools available when evaluating a small business acquisition.

But it is also one of the easiest concepts to misunderstand.

Over the years, we have found that buyers who take the time to understand SDE become more confident, ask better questions, and make better acquisition decisions.

And sellers who maintain clean books and reasonable add-backs usually achieve higher valuations and smoother transactions.

The numbers on a tax return tell part of the story.

SDE is an attempt to tell the rest of it.

If you are an E2 Visa investor, read my article on how you may compete with local buyers