TL;DR: Seller's Discretionary Earnings (SDE) is the primary valuation metric for small business acquisitions under $5 million in enterprise value. It normalizes the income stream for a single-owner business, showing a buyer what the business actually generates. Get this number wrong and you overpay. Get it right and you know what you're buying.
The number that determines what a business is worth
Every small business acquisition starts at the same question: what is this business actually producing? The answer isn't revenue. It isn't net income. It's Seller's Discretionary Earnings, and according to the Stanford Graduate School of Business Search Fund Primer, SDE is the standard by which acquisition candidates in the lower middle market are evaluated and priced.
Most small businesses are owner-operated. The owner is the CEO, the head of sales, and sometimes the person doing the actual work. Their compensation (salary, benefits, personal expenses run through the business) is baked into the income statement. A buyer replacing that owner needs to see through those expenses to understand what the business earns before any operator is paid.
That is what SDE does. It normalizes the earnings stream so a buyer can compare the real economic output of the business against its asking price.
How SDE is calculated
SDE starts with net income, then adds back specific items that distort the real picture for a prospective owner-operator.
The standard calculation:
Net income
+ Interest expense
+ Depreciation and amortization
+ Taxes (federal, state, local)
+ Owner's salary (one working owner)
+ Owner's benefits (health insurance, retirement contributions)
+ Personal expenses run through the business
+ One-time, non-recurring expenses
= Seller's Discretionary Earnings
The owner's salary addback is the critical piece. If the current owner pays themselves $180,000 per year and a buyer intends to work the business in the same role, those earnings are available to the new owner. They're part of what makes the business worth buying.
One-time expenses matter too. A year where the owner replaced the HVAC, settled a lawsuit, and replaced a key employee will show artificially suppressed net income. Adding those back shows what the business earns in a normal year.
SDE versus EBITDA: where each applies
SDE and EBITDA measure related but distinct things. Understanding the difference tells you which metric to use and when to be skeptical of a seller who conflates them.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a management-level metric. It doesn't add back the owner's compensation. That's because EBITDA is designed for businesses large enough to have a professional management team, where ownership and operation are already separated.
A business generating $600,000 in EBITDA needs a CEO, a CFO, and a head of operations. None of those salaries are in SDE's addback calculation.
SDE applies when ownership and operation are the same person. As a rule, businesses under $5 million in enterprise value are typically valued on SDE. Businesses above that threshold increasingly use EBITDA. The crossover point depends on the business, but the logic is straightforward: when the business is large enough that the new owner won't be operating it day-to-day, SDE's owner-compensation addback no longer reflects reality.
The Stanford research confirms this. The median search fund acquisition had a purchase price of $12 million at 6.4x EBITDA. At that enterprise value, EBITDA is the right metric. A buyer in this range is not expecting to replace the owner's labor personally.
Valuation multiples for SDE-based businesses
Once you have a clean SDE figure, the question is what multiple the business should trade at. SDE multiples for small businesses typically range from 2x to 4x, with the following factors driving where a business lands in that range.
Recurring revenue. A business with subscription contracts or predictable repeat customers commands a higher multiple than one with transactional, one-time sales. Buyers will pay for certainty.
Owner dependence. If the business cannot run without the current owner's relationships, technical skills, or client trust, the multiple compresses. The harder it is to transfer the value, the less a buyer should pay.
Industry and customer concentration. A business where 40 percent of revenue comes from one customer is priced accordingly. Concentration risk is real, and any competent buyer will pressure it.
Growth trajectory. Businesses showing consistent revenue growth over three or more years carry a premium. Flat or declining revenue requires a discount and a clear thesis for reversal.
EBITDA margin. Higher margins signal operational efficiency and pricing power. A 30 percent EBITDA margin attracts more buyer interest than a 12 percent margin at the same revenue.
Common errors in SDE analysis
Sellers overstate SDE. That's the default assumption going in. Not always through dishonesty, but because owners genuinely believe their addbacks are legitimate when they're not.
The most frequent errors:
Double-counting owner compensation. Some sellers add back both their salary and a family member's salary, when the family member performs a real function the buyer will need to replace with a paid employee. That expense is not discretionary — it's an operating cost.
Normalizing too aggressively. Sellers add back every unusual expense, including ones that are predictably recurring. If equipment breaks down every two years, that maintenance cost is not one-time. Average it over the cycle.
Ignoring working capital adjustments. SDE measures earnings, not cash flow. A business with long collection cycles or heavy inventory may show strong SDE while consuming cash. The working capital peg adjusts for this at close, but buyers need to understand it before signing a letter of intent.
Using a single year. One year of SDE is not a reliable basis for valuation. Sellers will naturally present their best year. Buyers should calculate SDE across three years minimum, weight the trend, and ask hard questions about any year that looks significantly better than the pattern.
How to validate SDE as a buyer
Request three years of tax returns. Not just P&Ls. Tax returns are harder to manipulate than internally prepared statements, and the IRS has a different standard for what counts as a deductible expense than a seller's accountant does.
Cross-reference reported revenue against bank statements. Revenue that shows up in the financials but not in the bank account is a red flag. So is revenue that appears in the bank but not in the financials — which suggests unreported income the seller is claiming is "really there" but that you cannot actually count on.
Build the addback schedule yourself. Don't accept the seller's recasting. Take the raw tax return line items and construct your own SDE from the ground up. Where your number differs from theirs, document the discrepancy and require an explanation before proceeding.
Get a Quality of Earnings report for any acquisition above $2 million in enterprise value. A third-party QoE digs into the revenue recognition, customer concentration, and expense normalization behind the stated SDE. The cost is $15,000 to $30,000. It has saved acquirers multiples of that on deals that looked clean until they weren't.
SDE in the search fund context
Search fund operators in the lower middle market spend their search phase filtering for businesses with defensible, verifiable SDE. Most of the companies they look at are run by baby boomer founders who have built real businesses but whose bookkeeping reflects years of optimizing for tax reduction rather than buyer clarity.
The addback conversation, where you walk through every normalization with the seller, is often where the deal gets made or falls apart. A seller who has run $50,000 per year in personal vehicle expenses through the business will either accept that this reduces their SDE by $50,000, or they won't. That conversation happens before the LOI, not after.
At Patriot Growth Capital, we evaluate acquisition candidates using the same discipline. Due diligence on a small business always starts with an independent reconstruction of SDE. We build it from source documents, not the seller's CIM.
The number that clears the fog
A clean SDE number answers the question that every acquisition comes down to: what does this business actually earn, after all the noise is removed?
Buyers who can calculate SDE accurately, pressure-test the addbacks, and translate the result into a defensible purchase price have a structural advantage over buyers who accept the seller's recast at face value. That discipline is what separates operators who build wealth through acquisition from those who discover problems after they've already signed.
Frequently Asked Questions
What is the difference between SDE and EBITDA in business acquisitions?
SDE adds back the working owner's salary and personal expenses, making it appropriate for businesses where the buyer will operate the company personally. EBITDA does not include this addback and is used for larger businesses where professional management is already in place or will be hired. For businesses below $5 million in enterprise value, SDE is typically the correct metric. Larger businesses, including most search fund acquisitions above $10 million, are priced on EBITDA.
What SDE multiple should I use when valuing a small business?
SDE multiples for small businesses typically range from 2x to 4x, depending on factors like revenue concentration, owner dependence, growth trajectory, and EBITDA margin. A business with recurring revenue, low customer concentration, and demonstrated growth will trade near the high end of that range. A business with a single dominant customer or heavy owner dependence will compress toward 2x or below.
Can a seller add back their spouse's salary in the SDE calculation?
Only if the spouse performs a role the buyer will not need to fill. If the spouse handles a real operational function (bookkeeping, customer service, office management), that salary is not discretionary. The buyer will need to pay someone to do that work. A legitimate addback applies only to compensation the buyer will not incur as the new owner-operator.
How many years of SDE should I analyze before making an acquisition offer?
Analyze at least three years of tax returns and construct independent SDE for each year. Weight the trend. A business with improving SDE over three years is valued differently than one where a single strong year inflates the average. Request bank statements alongside the tax returns to cross-reference reported revenue against actual deposits.
