Seller's discretionary earnings is a reconstructed number built from add-backs, and almost every small-business purchase is financed with debt the business's own cash flow is expected to repay - which makes the add-back schedule the single most consequential piece of arithmetic in the deal.
12 min read · Level 3
I would treat the add-back schedule as the single most important page in any small-business deal, more important than the headline multiple, because it is the page where a seller's own incentives are most directly opposed to a buyer's need for the truth. Every add-back removed lowers the seller's tax bill during ownership and raises the price they can ask for on the way out - which is not evidence of dishonesty, but it is evidence that nobody involved in producing that schedule was working for the buyer. The debt sizing compounds the stakes rather than diluting them: because the loan is financed against the business's own projected cash flow rather than the buyer's personal balance sheet, an inflated SDE does not just mean an inflated price - it means a debt-service obligation set against earnings that may not actually be there, in a structure where the bank's collateral is largely the same business whose numbers are in question. The buyers who get hurt in this asset class are rarely the ones who paid a slightly high multiple for a real business. They are the ones who financed a real multiple against an imaginary SDE.
Public-company earnings arrive already cleaned up by an accounting department and an audit. Small-business earnings arrive as whatever a bookkeeper or an accountant produced for the purpose of minimising the owner's tax bill - which is a completely reasonable thing for an owner to have optimised for, and a completely unreasonable number to hand a buyer without adjustment. Seller's discretionary earnings (SDE) is the reconstruction: start from the reported net income and add back everything that was a choice rather than a genuine cost of running the business.
Reported net income 40,000 + Owner's salary 65,000 + Owner's personal health insurance run through the business 8,000 + One-time legal settlement (non-recurring) 12,000 + Interest expense 5,000 + Depreciation and amortisation 10,000 ------------------------------------------------------------------- Seller's discretionary earnings (SDE) 140,000
Every line added back is a real cash outflow or a real accounting entry - the point of SDE is not that these things did not happen, but that a new owner might not incur them in the same way (a different owner might not draw the same salary, will not repeat a one-time settlement, and inherits a different capital structure with different interest and depreciation). SDE is deliberately not the same measure as EBITDA: EBITDA assumes a market-rate management team is already in place and being paid, while SDE assumes the opposite - that the owner's own labour is unpaid and available to be added back. Using the wrong one when comparing a small business against a larger, professionally run one compares two things that are not alike.
The purchase price is then this SDE multiplied by a multiple set by the market for businesses of this type and size - lesson three is entirely about where that multiple comes from. Take 2.6x on the 140,000 above:
Purchase price 140,000 x 2.6 = 364,000
Almost nobody pays this in cash. The dominant financing pattern for small-business acquisitions is a government-backed small-business loan requiring a modest buyer down payment, sometimes combined with seller-financing - the seller agreeing to accept part of the price over time, subordinated to the bank.
Down payment (10% of price) 36,400 Loan amount (90% of price, financed) 327,600
That loan is not a personal mortgage sized against the buyer's own income. It is sized against the business's own cash flow, at an interest rate and term the bank sets, and the annual payment on it - at, say, 10% over ten years - works out as follows:
Annuity factor at 10% over 10 years 6.1446 Annual loan payment 327,600 / 6.1446 = 53,315.39
That 53,315.39 is not optional. It is owed to the bank whether the business has a good year or a bad one, and it comes directly out of the same SDE that was used to justify the price in the first place - which is exactly why the bank checks the relationship between the two before agreeing to lend at all.
Because SDE is a reconstruction rather than a reported fact, the quality of every add-back is the quality of the whole valuation, and a buyer who accepts a seller's add-back schedule without verifying each line is accepting the seller's own account of which of their expenses were genuinely discretionary. A "one-time" legal settlement that recurs every eighteen months is not one-time. A family member on payroll doing real work is not a pure add-back. This is not a minor bookkeeping quibble - on the numbers above, an unjustified 20,000 of extra add-backs at a 2.6x multiple inflates the purchase price by 52,000, which is money paid for earnings that will not actually be there next year.
The financing structure matters just as much, because leverage here works in both directions at once. Financing 90% of the price with debt means a buyer's own capital of 36,400 controls a 364,000 asset - a small equity check for a meaningful business, which is part of why small-business acquisition is accessible to people without large personal wealth. It also means the business's cash flow has a fixed, contractual first claim against it before the owner sees a dollar of return, in every year, regardless of how trade actually goes.
This is what a lender's debt-service-coverage-ratio test is actually checking: not whether the business looks profitable, but whether the cash flow available to service debt comfortably exceeds the payment owed, so a bad month or a slow season does not turn into a missed payment. Most SBA-style lenders want to see something like 1.25x coverage as a floor; anything meaningfully above that is margin for the ordinary unevenness of a small business's year, and anything close to 1.0x means the loan structure has no room at all for a bad quarter.
Seller financing changes this picture again. A seller note is typically subordinated - the bank gets paid first - and it aligns the seller's interest with the business continuing to perform, since their own remaining payments depend on it. A seller unwilling to leave any of the price on a note is itself a piece of information worth taking seriously: it can mean nothing at all, or it can mean the seller does not want their own future income tied to how the business performs after they leave.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Working through the full chain on one bakery, using the numbers already built above.
Step one: reconstruct SDE. Reported net income 40,000, plus owner's salary 65,000, plus personal health insurance 8,000, plus a one-time legal settlement 12,000, plus interest 5,000, plus depreciation and amortisation 10,000. Total SDE: 140,000.
Step two: price it. At a market multiple of 2.6x for this size and type of business, purchase price is 140,000 x 2.6 = 364,000.
Step three: finance it. A 10% down payment is 36,400; the financed loan is 327,600.
Step four: size the debt service. At 10% interest over a ten-year term, the annuity factor is 6.1446 and the annual payment is 327,600 / 6.1446 = 53,315.39.
Step five: check the coverage. SDE of 140,000 against annual debt service of 53,315.39 gives a debt-service-coverage ratio of 140,000 / 53,315.39 = 2.63x. That comfortably clears a typical 1.25x lender floor, which is exactly the margin a lender wants to see before extending 90% financing against a business whose earnings depend heavily on one person continuing to show up.
Step six: what is actually left for the owner. After the loan payment, 140,000 - 53,315.39 = 86,684.61 remains - and this is where lesson one's distinction matters again. That 86,684.61 already includes the reconstructed owner's salary of 65,000, so the true incremental capital return, after paying the debt and after valuing the owner's own labour at market, is smaller still: 86,684.61 - 65,000 = 21,684.61, or roughly 5.95% on the 364,000 price - a modest capital return on its own, which is the honest reminder that in a heavily levered, owner-operated purchase, the job and the equity growth (paying down the loan principal every year) are doing most of the work, not a cash yield.
Treating the seller's add-back schedule as neutral bookkeeping rather than as a set of claims that need independent verification, each one, against source documents rather than a summary spreadsheet.
Confusing SDE with EBITDA and comparing a small owner-operated business's multiple directly against a larger company's EBITDA multiple, without adjusting for the fact that one assumes unpaid owner labour and the other assumes a paid management team already in place.
Sizing the debt only against the stated SDE without stress-testing it against a worse year. A 2.63x coverage ratio on this year's numbers can fall close to 1.0x on a 20-30% revenue decline, and a lender's minimum is a floor for an ordinary year, not a guarantee against a bad one.
Forgetting that the reconstructed owner's salary inside SDE is not extra profit on top of a market wage - it is the wage, restated. Adding the full SDE to the picture of "what this pays me" and then also counting a market salary as a separate benefit double-counts the same money.
Do not accept a broker's summary total. Ask for the tax returns and bank statements behind every add-back and check whether each one is genuinely discretionary or, for a family-payroll or a "one-time" item, actually recurring in substance.
Use the annuity formula rather than a rough percentage, because small differences in rate or term move the payment meaningfully at these loan sizes, and that payment is what the coverage ratio is measured against.
Recompute the debt-service-coverage ratio at, say, a 20% and a 30% drop in SDE. If a plausible bad year pushes coverage close to or under 1.0x, the loan structure has no room in it for the ordinary unevenness a small business actually experiences.
After debt service, subtract a market-rate wage for the work you will personally do before calling what is left a return on your capital. That final figure, not the SDE and not the post-debt-service figure, is the number to compare against other investments.
A willing seller note, subordinated to the bank, is a signal of confidence in the business continuing to perform and reduces the buyer's own cash requirement. A flat refusal is not automatically a red flag, but it is a question worth asking directly rather than assuming.
Whenever a listing's SDE figure is presented as a finished number, before agreeing to any purchase price, and whenever comparing financing terms across more than one lender or deal structure.
Do not use a single year's coverage ratio as proof the deal is safely financeable - a business with genuinely seasonal or cyclical revenue needs the ratio checked against its worst realistic year, not its most recently reported one.
It is a common pattern in small-business financing packages for the debt-service-coverage ratio to be calculated against the single most recent, and often best, year of SDE - frequently a year that included a one-time boost such as a large contract or a temporary cost reduction. Buyers who accept that year's ratio at face value are, without realising it, financing a loan sized against a best case rather than a typical one. The businesses that run into trouble servicing acquisition debt are disproportionately the ones where nobody recomputed the ratio against an ordinary or a weak year before signing.
Ask which year's SDE the coverage ratio was calculated from, and recompute it yourself against the weakest of the last three years, not the strongest.
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