How to calculate seller's discretionary earnings

Almost every small business valuation starts with seller's discretionary earnings, usually shortened to SDE. It is the cash a single owner-operator can expect the business to produce for them in a year. It rarely matches the profit on the tax return.

Start with reported profit

Take a landscaping and grounds maintenance company with $2.4M in revenue. The return shows $95K of net income. That figure has been shaped by tax planning, not by economics, so it is a starting point rather than an answer.

Add back what a new owner would not repeat

Owner's compensation of $180K. Payroll taxes on that compensation of about $14K. Interest expense of $22K on equipment notes that will not transfer. Depreciation and amortization of $86K. A family member on payroll at $45K who does not work in the business. Personal vehicle and travel expenses of $18K. One-time legal costs of $12K from a settled dispute.

The resulting figure

Reported profit of $95K plus $377K of add-backs gives SDE of about $472K. That is the number a multiple gets applied to, and it is nearly five times the profit shown on the return.

Subtract what the buyer will actually have to spend

Add-backs cut both ways. If the owner worked sixty hours a week doing estimating and crew supervision, and a buyer would have to hire a manager at $95K to replace that, a careful buyer normalizes for it. Equipment that genuinely needs replacing at $60K a year is a real cost, not a paper one, and gets treated as such.

Why this matters more than the multiple

Owners tend to negotiate hard over whether the multiple is 3x or 3.5x while accepting the earnings figure without argument. On $472K, half a turn is $236K. But a $60K disagreement about add-backs is worth about $200K at the same multiple. The earnings line is where most of the money is decided.

Clean, documented add-backs supported by statements and invoices are the cheapest value you can create before a sale. An add-back a buyer cannot verify is an add-back that quietly disappears.