Seller's discretionary earnings (SDE): what it means and how buyers test it

Published October 25, 2026 · Facts checked as of October 2026

When a broker lists a business with "cash flow: $240,000", that figure is almost always seller's discretionary earnings. It's meant to answer a simple question: if you bought this business and ran it yourself, how much money would it generate for you each year before debt payments and income tax? It's a useful number. It's also the easiest number in the deal to inflate, because it's built from the seller's own judgment about which costs "don't count".

The SDE formula

Start with the business's pre-tax profit and add back:

1. One owner's compensation: salary or W-2 wages, the employer payroll taxes on them, and owner benefits such as health insurance and retirement contributions.
2. Interest expense, because you'll have your own financing and the seller's debt is paid off at closing.
3. Depreciation and amortization, which are accounting entries, not cash spent this year.
4. Discretionary expenses: personal costs the owner runs through the business (a car the family uses, personal phone, travel that wasn't really for business).
5. Non-recurring expenses: genuinely one-time costs, like a lawsuit settlement or a move.

Some practitioners also subtract one-time income, such as an insurance payout or a PPP-style grant, which people forget to do far more often than they forget to add back expenses.

SDE calculator does the arithmetic.

A worked example

Notice what the depreciation add-back hides. The business owns trucks. They wear out. SDE adds back depreciation, but a buyer still has to replace equipment, so set aside a realistic yearly capex reserve when you work out what you can actually take home.

What doesn't belong in SDE

• A second owner's salary, unless that job truly disappears after the sale.
• Costs you'll still have. If the owner adds back his wife's salary as "not really working", ask who answers the phones after closing.
• Recurring "one-time" costs. A repair or a legal bill that shows up in some form every year is a normal cost of the business.
• Income that isn't on the tax return. Unreported cash can't be verified and no lender will count it. Don't pay for it. Read buying a cash business.
• Pro forma savings. "You could cut the second shift." Maybe you could, but that's your upside, not the seller's earnings.

How lenders look at SDE

SBA lenders don't price your deal on SDE. They test whether the business can carry the debt. Under SOP 50 10 8.1, the lender's debt service coverage for an initial acquisition must be at least 1.25, using EBITDA divided by post-closing debt payments, on either the last fiscal year or the average of the last two. Lenders may make adjustments for seller discretionary expenses, owner compensation, non-recurring income and similar items, but each one must be justified in the credit memo, and changes to owner compensation must be backed by a global cash flow analysis. If an add-back can't be documented, assume the lender will remove it.

For deals with a purchase price of $3 million or more, the lender also orders a Quality of Earnings report and must use its adjusted earnings in the coverage test. That report specifically has to identify every add-back and test it, including above- or below-market owner pay, related-party transactions and deferred maintenance.

How to test a seller's SDE

1. Start from the tax return, not the broker's recast. Make sure the starting profit matches the filed return.
2. Tick every add-back to a document: payroll records, invoices, card statements, the depreciation schedule, loan statements.
3. Look at three years. One-time costs that recur and owner perks that grow are both visible over time.
4. Check revenue against bank deposits with a proof of cash. An add-back analysis is worthless if revenue itself is overstated.
5. Subtract what you'll add. If you won't do the owner's job yourself, a manager's salary comes out. If the owner does his own repairs or books, you'll pay someone.

The number you end with is often lower than the listing. That gap is the most useful thing you'll learn about the deal, because the price was almost certainly calculated on the higher number.

Owner discretionary earnings: is it the same as SDE?

Mostly, yes. Owner discretionary earnings, seller's discretionary earnings (SDE), seller's discretionary cash flow and owner benefit all describe the total financial benefit one working owner gets from a business: pre-tax profit plus that owner's pay and perks, interest, depreciation and one-time costs.

The label matters much less than what was added back to get there. Ask for the calculation, line by line, whatever it's called.

Buyers see four or five names for the same figure across listings, CIMs and broker emails. It's worth knowing they're siblings, and worth knowing where the family resemblance ends.

The names you'll see

What to do with any version

1. Ask for the calculation with a line for every adjustment.
2. Check the starting profit matches the tax return.
3. Check whether one owner's or two owners' pay was added back.
4. Rate each add-back solid, shaky or unsupported. See add-backs.
5. Rebuild it yourself with the SDE calculator.

For how listings present it, see how to read a business listing.

Seller's discretionary earnings formula: how to calculate SDE

SDE = pre-tax net profit + one owner's salary or wages + that owner's payroll taxes and benefits + interest + depreciation and amortization + documented personal (discretionary) expenses + genuinely one-time expenses − one-time income.

Start from the tax return, not the seller's spreadsheet, and attach a document to every add-back. The worked examples below show where each number comes from for a sole proprietor (Schedule C) and an S corporation (Form 1120-S).

The formula is short. The work is in finding each number on the right document and deciding whether it belongs. Our SDE calculator does the arithmetic; this page shows the reasoning.

The formula, line by line

Example 1: sole proprietor (Schedule C)

Example 2: S corporation (Form 1120-S)

Common formula mistakes

• Adding back a second owner's or a family member's salary when the work continues.
• Adding back distributions (they were never deducted).
• Forgetting to subtract one-time income.
• Starting from an internal P&L that doesn't match the tax return. See tax returns vs P&L.
• Treating depreciation as free money when equipment will need replacing. See depreciation add-backs.

Frequently asked questions

Sources

• SBA SOP 50 10 8.1, Appendix 15 (adjusted debt service coverage, add-back justification)
• IRS Publication 535, Business Expenses
• IRS Publication 946, How to Depreciate Property
• IRS: Business structures (Schedule C, S corporations)

Related guides

• Add-backs: which ones hold up when you buy a business
• SDE vs EBITDA: what's the difference when you buy a business?
• Owner salary add-back: getting owner pay right in SDE
• Proof of cash: checking that a seller's revenue really reached the bank
• SDE multiplier: what moves the multiple on a small business
• More in Earnings, SDE and add-backs →

General information, not legal, tax, financial or investment advice. Rules and lender practices change; check the linked sources and talk to your attorney, CPA and lender about your deal. Examples with named numbers are illustrations, not real businesses. OKtoBuy does not value businesses or give price opinions.