Seller's Discretionary Earnings vs EBITDA

Seller's discretionary earnings adds the owner's entire compensation and personal perks back to profit, because a single owner-operator buyer steps into that seat and takes that money. EBITDA does not: it leaves a market-rate salary for a replacement manager in the expenses. SDE is the standard metric for owner-operated businesses, usually under roughly $5 million in value, and EBITDA takes over once a company has real management. On the same set of books, SDE is always the larger number.

The distinction sounds like accounting trivia until you notice what it does to a credit decision. Run a deal on the wrong metric and the debt service coverage ratio in your memo is overstated by the entire cost of a general manager, which on a small company is often the difference between a loan that works and a loan that defaults in year two.

The two calculations, on the same company

Take a company with $2,000,000 in revenue and $150,000 of net profit on the tax return. The owner takes a $180,000 salary, runs a personal vehicle through the business at $12,000, expenses $8,000 of personal travel, carries $25,000 of interest on a note that will be paid off at closing, books $60,000 of depreciation, and had a one-time $20,000 legal settlement last year. A market-rate general manager for this business would cost $110,000.

Same books. A $110,000 gap. At a 3.5 times multiple that is $385,000 of value, and at a 10 year amortization it is roughly the annual debt service on several hundred thousand dollars of additional loan. Nothing about the business changed. What changed is the assumption about who runs it.

Which metric applies when

The rule of thumb the market actually uses:

The failure mode is a mismatch: a buyer who plans to keep their day job, financed on an SDE figure. That buyer will hire a manager. The manager's salary is real, recurring and senior to the lender's payment in every practical sense, because if the manager is not paid, the business stops. Underwrite that deal on EBITDA even if the broker's book quotes SDE.

What counts as a legitimate add-back?

An add-back is legitimate when the expense is either non-cash or genuinely will not exist for the new owner. That gives you a short list that survives review:

• Depreciation and amortization. Non-cash, always come back. Watch for a business that has been under-investing, because deferred capital spending flatters earnings and hands the buyer a bill.
• Interest on debt retired at closing. The buyer will not carry it, so it comes back and the new debt goes into the coverage test instead.
• Owner compensation and benefits, in the SDE calculation only.
• Personal expenses run through the business: vehicle, personal travel, a spouse's phone. Documented ones only.
• Truly one-time items: a settled lawsuit, a move, a failed product launch that is over.

And the ones that get struck, in the order lenders find them: a recurring expense relabeled as one-time; a family member on the payroll who does real work the buyer will have to replace; "normalized" rent when the owner also owns the building and the new lease is at market; marketing spend cut to zero for a year to fatten the earnings; and inventory or maintenance that was simply skipped. The test to apply, every time, is whether the expense will exist again next year under a new owner. If it will, it is not an add-back, whatever the seller's schedule calls it.

Is SDE the same as cash flow?

No, and treating it as cash flow is how buyers get in trouble. SDE ignores capital expenditure, working capital swings and taxes. A business with $455,000 of SDE that has to replace $80,000 of equipment a year and fund growing receivables does not have $455,000 to hand a lender and a buyer. This is why a lender computes coverage from adjusted cash flow with a capital allowance and a buyer's wage deducted, not straight from the headline SDE on a broker's teaser.

How do you verify the add-backs are real?

Against the documents, not against the seller's schedule. The tax returns give you the depreciation, the interest and the officer compensation directly. The bank statements tell you what the business actually collected and what it actually paid, which is where a supposedly one-time expense reveals itself as a monthly debit. Reconciling reported revenue against netted deposits is the single highest-yield check in the file, and it is the one most often skipped because it is tedious by hand. Automating that read is what tax return analysis software and bank statement analysis software are for: the add-back schedule gets built from the returns with each line sourced, and the deposits get totaled net of transfers so the revenue claim can be tested rather than believed. Our walkthrough of how to calculate add-backs in business cash flow goes line by line.

When the seller's financials arrive as scanned PDFs rather than a clean export, which is the usual case, running them through document data extraction first at least gets the figures into a form you can check instead of retyping.

Why lenders care more than sellers do

A seller wants the biggest defensible earnings number because the price is a multiple of it. A buyer wants the truest one because they will live on it. A lender wants the one that will still be there in year three, under a new owner, in a worse economy, after the buyer takes a wage. Those three interests only meet if the add-backs are sourced and the metric matches the buyer.

If you are underwriting the deal, that means starting from the documents rather than the summary: rebuild the earnings yourself, reconcile them to the bank, then run the coverage. The full sequence is in our guide to how to underwrite a business acquisition loan, and the analysis behind it is what business acquisition underwriting software computes automatically, traceable to the source line.