Seller's Discretionary Earnings (SDE)

Seller's discretionary earnings, sometimes called seller's discretionary cash flow or owner's benefit, answers the question a buyer of a small business asks first: if I own and run this business myself, how much cash will it give me each year before debt payments, income tax and reinvestment?

Accounting profit does not answer that. Owners of private Ontario corporations pay themselves in different mixes of salary and dividends, run some personal costs through the company, and carry one-time expenses that will not recur. SDE strips out those choices and rebuilds earnings from the point of view of a single working owner.

SDE is used mainly for owner-operated businesses such as restaurants, trades, clinics and agencies, where the buyer will step into the owner's job. A business broker will usually build the listing price on it. Larger, management-run businesses are priced on adjusted EBITDA, compared below. Neither is a measure defined by Accounting Standards for Private Enterprises (ASPE); each is a negotiating number built from the financial statements.

Lamba Law's free business valuation calculator uses SDE to produce a directional value range.

The usual build-up starts with net income before tax from the financial statements and adds back:

1. Interest expense, because the buyer will finance the purchase in its own way.
2. Depreciation and amortization, which are non-cash charges.
3. One owner's total compensation: salary, bonus, the employer's share of payroll costs and benefits paid for that owner.
4. Discretionary personal expenses run through the business, such as a personal vehicle, family phone plans or personal travel.
5. Genuinely non-recurring costs, such as a one-time lawsuit settlement or a relocation.
6. Non-operating items, such as investment income or expenses tied to assets that will stay with the seller.

Adjustments also run the other way. If a family member works for below-market pay, or the business pays a related landlord below-market rent that will rise after closing, the market cost is deducted.

Unreported cash revenue is never a legitimate add-back. A buyer cannot verify it, a lender will not lend against it, and putting it in writing documents a tax problem. Personal costs deducted by the company raise a related issue covered under personal vs. business expenses.

Both measures start from the same statements. They differ on one line: the owner's pay.

The two cannot be mixed. Applying an EBITDA multiple to SDE overstates value, because the buyer still has to pay someone to do the owner's job. Interest and depreciation are added back in both measures, but neither is free cash: the buyer will carry acquisition debt and will eventually replace equipment.

A Chartered Business Valuator preparing a business valuation report makes similar normalizing adjustments to earnings, but tests them against supporting documents and states the assumptions behind each one.

SDE usually appears in the broker's marketing package, not in the financial statements. That gap matters legally.

Representations. Sellers typically give representations and warranties about the financial statements, books and records, undisclosed liabilities and the absence of material changes since a stated date. A buyer who priced the deal on SDE should also ask for a representation that the add-back schedule it received is accurate, that each add-back was actually incurred and that it will not continue after closing. Sellers often resist, and that negotiation is a fair test of how solid the add-backs are.

Entire agreement. Most purchase agreements contain an entire agreement clause limiting claims based on statements made outside the contract. If the SDE schedule is not tied into the agreement, a buyer may have little recourse when an add-back proves wrong.

Due diligence. Buyers and their accountants test SDE against bank statements, tax returns and payroll records during due diligence, sometimes through a formal quality of earnings review.

Earn-outs. SDE is a poor earn-out metric because, after closing, the buyer controls owner pay and discretionary spending. Earn-outs more often use revenue, gross profit or a carefully defined EBITDA that fixes the accounting principles and lists the costs the buyer may not charge against the business.

Working capital. A price based on an SDE multiple assumes the business is delivered with a normal level of inventory and receivables. A working capital adjustment protects that assumption.

Sellers can see how their records will look to a buyer with the free sale readiness checker.

Dario Conti is selling his Brampton landscaping company to Aisha Khan, who plans to run it herself. Dario's broker presents SDE of $350,000, built from:

• Net income before tax: $152,000
• Dario's salary and benefits: $95,000
• Depreciation: $40,000
• Interest on equipment loans: $12,000
• Dario's personal truck lease: $14,000
• A one-time legal fee: $9,000
• Salary paid to Dario's spouse: $28,000

At a multiple of 2.5 times SDE, the asking price is $875,000.

Aisha's accountant reviews three years of statements and payroll records. Dario's spouse does the company's bookkeeping, so the broker's treatment of her salary as a family expense does not hold: Aisha will have to hire a bookkeeper. Removing that add-back reduces SDE to $322,000 and, at the same multiple, the price to $805,000.

The parties sign at $805,000. Dario represents that the financial statements and the revised add-back schedule are accurate, and $80,000 is retained as a purchase price holdback for 12 months against indemnity claims. No claims are made, and the holdback is released at the end of the year.