The seller claims $500K in earnings. Their tax return shows $100K. The $400K gap is Seller's Discretionary Earnings—and getting it wrong at a 3x multiple means overpaying by hundreds of thousands.
This guide is designed to sit open while you review financials. Use it to kill bad deals before you spend $20K on diligence.
What SDE Is (And What Lenders Actually Use)
Seller's Discretionary Earnings (SDE) = Net Income + Interest + Taxes + D&A + Owner Comp + Discretionary Expenses
SDE is a valuation metric—what the business theoretically earns for an owner-operator. But your lender uses a different number.
Lenders calculate adjusted EBITDA from tax returns:
Start with net income from the tax return (not broker P&L)
Add documented, verifiable add-backs
Subtract your required compensation
Subtract realistic maintenance CapEx
Require 1.25–1.50x debt service coverage on what's left
A $400K SDE might only support $280K in lender-adjusted EBITDA. That gap kills more deals than bad businesses do.
Verdict: If you LOI off SDE but finance off lender EBITDA, you will overpay (if you can even get the deal done).
The Add-Back Matrix
Accepted | Contested | Rejected | Hidden Negatives |
|---|---|---|---|
Interest expense | Travel (unless purely personal) | Cell phone/internet | Free family labor |
Depreciation & amortization | Meals & entertainment | "Miscellaneous" | Below-market rent |
Income taxes | Home office | Club memberships | Deferred CapEx |
One owner's W-2 salary | Personal vehicle (partial) | Undocumented expenses | Underpaid staff |
Verdict: If it's not on the tax return with documentation, assume the lender rejects it.
Owner Compensation: The #1 Battleground
Sellers add back their full salary. Lenders subtract what you need to live on. The math diverges fast.
The trap: Owner takes $200K, works 60 hours as GM + sales + technician. You plan semi-absentee ownership. You can't add back $200K—you need to subtract $100K+ for a GM replacement.
Worse trap: Owner takes $80K (below market) because she's pulling distributions. Market replacement cost is $150K. That's a negative $70K adjustment.
Multiple owners: You only add back one salary. The other owner's function needs replacement—subtract that cost.
Example: Seller adds back $200K. GM replacement costs $130K. Real add-back = $70K.
Verdict: Owner comp add-backs require a replacement cost analysis, not just a W-2.
One-Time Expenses: The Recurrence Test
"One-time" is the most abused phrase in CIMs.
Actually one-time: Lawsuit settlement (first in company history), transaction costs, roof replacement, COVID shutdown.
Not one-time: Legal fees that appear in 3 of the last 5 years. Equipment repairs on aging assets. "Marketing initiatives" every Q4.
Verdict: If it's happened twice, budget for it. Three times = recurring expense, not add-back.
🚨 Deal Killers (Immediate Reprice or Walk)
Add-backs exceed 30% of claimed SDE
Free family labor + below-market rent together
"One-time" legal expenses appearing 2+ times in 5 years
Owner doing sales + ops + admin with no replacement plan
Customer concentration >35%
The Negative Adjustments Sellers Hide
These reduce SDE but never appear in CIMs.
Free family labor: Spouse does bookkeeping for $0. You'll pay $40K–$60K/year. That's not an add-back—it's a hidden expense.
Below-market rent: Owner charges the business $2K/month; market rate is $5K. You inherit a $36K/year cost increase.
Deferred maintenance: Seller milked the business for 5 years. Equipment is aging, trucks are high-mileage. You inherit the CapEx bill in year one.
Underpaid staff: Key employees are 20% below market. Post-sale, they expect raises—or they walk.
None of these are fatal unless they were hidden—hidden negatives signal a seller integrity problem.
Verdict: Always ask: "What does this business cost to run if the seller's family isn't subsidizing it?"
How Lenders Actually Underwrite
SBA lenders start with tax returns, not broker financials. "Odds and ends which the seller hasn't tracked through the P&L and tax return wouldn't be counted toward cash flow." —Live Oak Bank
The DSC formula:
Net Income (from tax return) + Interest + Taxes + D&A + Accepted Add-backs − Your Required Comp − Maintenance CapEx − Replacement Salaries = Cash for Debt Service
Divide by annual debt payments. Lenders require 1.25–1.50x minimum.
What lenders reject almost universally: Meals and entertainment, travel (unless documented as purely personal), cell phone, internet, anything without tax return documentation.
Here's exactly how underwriting destroys inflated SDE:
Real Example: A $1.4M HVAC deal died in underwriting when broker SDE of $390K became $230K of lender EBITDA after owner comp, CapEx, and rejected add-backs. Valuation gap: $480K. No seller note. Deal collapsed.
The Valuation Gap Problem
Seller's SDE: $400K → Seller's price at 3x: $1.2M
Lender's adjusted EBITDA: $300K → Lender's supportable value: $900K
Gap: $300K
Three outcomes:
You inject more equity to cover the gap
Seller carries more debt (10–15% seller note on 5+ year term)
Deal dies or you renegotiate price down
Verdict: Get aligned with your lender on adjusted EBITDA before you sign a purchase agreement. LOI is cheap to walk away from.
Pre-LOI SDE Reality Check (10-Minute Kill Screen)
This is not diligence—this is to prevent emotional anchoring to inflated SDE before real documents surface.
If you don't yet have tax returns, payroll, or bank statements, this is the exact filter you should be using before writing an LOI.
Tax return match: Does the CIM's net income match the tax return? If tax returns aren't provided pre-LOI, treat all add-backs as provisional until verified in diligence.
Add-back ratio: Are add-backs >30% of claimed SDE? Assume haircut unless proven otherwise.
Owner comp replacement: What does it cost to replace the owner's actual functions? Subtract that from the add-back.
Family labor audit: Who works for free or below market? Price their replacement.
Rent reality: Is rent at market rate? If owner owns the building, assume rent increases post-close.
CapEx reality: If fleet average age >7 years or major equipment >12 years, assume near-term CapEx and haircut SDE.
Recurrence check: Have any "one-time" expenses appeared more than once in 5 years?
Customer concentration: Any customer >35% of revenue = deal killer. 25–35% = haircut the multiple.
Staff compensation: Are key employees paid at market? If not, budget for raises or turnover.
Documentation test: Can every add-back over $10K be traced to a receipt, invoice, or W-2?
Rule of Thumb: If a deal fails 2+ tests, reprice. If it fails 4+, watch out.
This checklist exists because most buyers discover fake SDE after they've spent 60 days and $20K. Use it before you get emotionally anchored.
For what happens after LOI—when you verify these numbers with source documents—see our guide: Quality of Earnings Reports for Small Business Acquisitions.
Join the EBIT WhatsApp community to connect with operators who've navigated this transition—and the ones preparing for it next.
Disclaimer: This guide is for educational purposes only and does not constitute legal, financial, tax, or investment advice. Business acquisitions involve significant risks, and outcomes can vary widely based on individual circumstances. Always consult with qualified professionals including attorneys, CPAs, and financial advisors before making acquisition decisions. The EBIT Community does not guarantee the accuracy of information provided or the success of any acquisition strategy. Past performance and examples do not guarantee future results.
