What is Seller's Discretionary Earnings (SDE) and how is it calculated?
Seller's Discretionary Earnings (SDE) is the total financial benefit available to a single owner-operator of a business, calculated by adding back owner compensation, discretionary expenses, and non-cash charges to net profit before taxes. It is the primary valuation metric for owner-operated businesses with annual revenue below $2 million in Canada.
What is Seller's Discretionary Earnings (SDE)
SDE represents the full earnings potential available to an owner who actively works in the business. Unlike other earnings metrics, SDE includes the owner's salary as part of the business benefit because it assumes the buyer will replace the owner and capture both the profit and the compensation the previous owner paid themselves.
Business brokers overwhelmingly use SDE when marketing businesses under $5 million in transaction value. It is most commonly used for businesses with annual revenue below $2 million in the Canadian market.
How SDE differs from EBITDA
SDE and EBITDA are both earnings metrics, but they serve different types of businesses:
- SDE is used for owner-operated businesses where the owner actively works in the business. It adds back the owner's compensation because the metric assumes owner-operator involvement.
- EBITDA is used for managed businesses with professional management in place. It subtracts a market-rate manager's salary before adding back interest, taxes, depreciation, and amortization.
The transition from SDE to EBITDA typically occurs when a business requires or has professional management and the owner is no longer performing day-to-day operational duties.
Step-by-step SDE calculation
SDE starts with net profit from the income statement before income taxes. The formula is:
Net Profit (before tax) \+ Owner's salary and benefits \+ Interest expense \+ Depreciation and amortization \+ Discretionary and one-time expenses = Seller's Discretionary Earnings (SDE)
Each component has a specific purpose:
- Owner's salary is added back because SDE represents the total financial benefit available to a single owner-operator.
- Interest expense is added back because it represents financing costs specific to the current owner's capital structure, which may change under new ownership.
- Depreciation and amortization are added back because they are non-cash expenses that reduce reported profit but don't represent actual cash outflow in the period.
Common add-backs in SDE calculations
Typical add-backs in SDE calculations include:
- Owner's salary and benefits (health insurance, retirement contributions)
- Personal vehicle expenses run through the business
- Family members on payroll who don't contribute proportionate value
- Personal travel or meals charged to the business
- Interest expense
- Depreciation and amortization
- One-time or non-recurring expenses (legal fees for a one-time dispute, major equipment repairs, pandemic-related costs)
One-time or non-recurring expenses can be added back if they are truly non-recurring. Discretionary expenses that can be added back include personal vehicle expenses run through the business, family members on payroll who don't contribute proportionate value, and personal travel or meals charged to the business.
Aggressive or unsupportable add-backs are a common source of valuation disputes between sellers and buyers. According to CABB Standard Practice Guidelines, each add-back in an SDE calculation should be documented with supporting financial records to withstand buyer due diligence.
When SDE is used in business valuation
SDE is used for owner-operated businesses where the owner actively works in the business, while EBITDA is used for managed businesses with professional management in place. SDE is the primary valuation metric for businesses with revenue under $1–2 million in Canada.
SDE calculation example
Example: Restaurant with owner-operator
| Line item | Amount | |---|---| | Net profit (before tax) | $75,000 | | Owner's salary | $60,000 | | Owner's health insurance | $8,000 | | Interest expense | $12,000 | | Depreciation | $15,000 | | One-time legal fees (lease dispute) | $5,000 | | SDE | $175,000 |
In this example, the restaurant shows $75,000 in net profit on the income statement, but the total financial benefit to an owner-operator is $175,000 when owner compensation, non-cash expenses, and one-time costs are added back.
This article is for informational purposes only and does not constitute financial, legal, or business advice. Every business sale is different. Before making decisions about valuation, pricing, or engaging an advisor, consult a qualified professional familiar with your specific situation.
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