When you buy or sell a small business, the first number on the table is usually not net income. It is either seller's discretionary earnings (SDE) or EBITDA, often with a multiple attached. The two look similar, both start from profit and add things back, but they answer different questions. Mixing them up is one of the fastest ways to overpay for a business or to price one so high that it never clears a lender's underwriting.
I'm Sergei Mochtchenkov, a CFA Charterholder. I prepare quality of earnings analysis and valuation work for buyers, sellers and lenders, and the SDE-versus-EBITDA question comes up often in small-business deals. This guide explains what each measure is, when each one fits, and how lenders and diligence providers test them.
What SDE measures
The International Business Brokers Association defines discretionary earnings as the earnings of a business before income taxes, non-operating income and expenses, nonrecurring income and expenses, depreciation and amortization, interest, and "one owner's entire compensation, including benefits and any non-business or personal expenses paid by the business" (IBBA Glossary).
The key phrase is one owner's entire compensation. SDE answers a specific question: how much cash, before financing and taxes, does this business produce for a single owner who works in it full time? That owner then uses the SDE to pay themselves, service acquisition debt and reinvest.
SDE fits businesses where the owner is the operator: a service firm, a clinic, a trades business, a single-location retailer. The buyer is usually an individual who will step into the owner's role.
What EBITDA measures
EBITDA is earnings before interest, taxes, depreciation and amortization. The SEC's guidance on non-GAAP measures states that "earnings" in EBITDA means net income under GAAP, and that measures calculated differently "should not be characterized as 'EBIT' or 'EBITDA'" but given a distinct title such as "Adjusted EBITDA" (SEC Non-GAAP Financial Measures C&DI 103.01). That rule applies to public companies, but the discipline is useful in private deals too. Reported EBITDA and adjusted EBITDA are different numbers and should be labeled that way.
In private transactions, the figure that matters is usually adjusted EBITDA. The IBBA describes it as earnings before the same financing, tax and non-cash items, "but after replacing that owner's/officer's compensation and benefits with the market rate compensation and benefits to replace that owner's/officer's functions."
EBITDA fits businesses with a management team in place, where the buyer may be a private equity fund, a strategic acquirer or an investor who will not run the business day to day.
The core difference: owner compensation
Both measures normalize for one-time items, financing and non-cash charges. The difference is how they treat the owner:
- SDE adds back the whole compensation of one working owner, including salary, payroll taxes, benefits and personal expenses run through the business.
- Adjusted EBITDA deducts a market-rate cost for someone to do the owner's job.
So for the same business, SDE is higher than adjusted EBITDA by roughly the market cost of replacing the owner. Neither number is "right." They describe the same business from the point of view of two different buyers.
Here is a simplified bridge for a hypothetical owner-operated business. The numbers are illustrative, not drawn from any client.
- Net income: 300,000
- Plus interest, taxes, depreciation and amortization: 100,000
- EBITDA: 400,000
- Plus a one-time legal settlement, supported by invoices: 30,000
- Plus the owner's actual compensation, benefits and payroll taxes: 180,000
- Less the market cost to hire a general manager to replace the owner: 140,000
- Adjusted EBITDA: 470,000
- Add back the market replacement cost again, because an owner-operator will do the job: 140,000
- SDE: 610,000
The bridge shows why the two figures can be far apart, and why the same multiple cannot be applied to both.
Match the multiple to the measure
A multiple is only meaningful when it is paired with the earnings measure it was derived from. An SDE multiple applied to adjusted EBITDA undervalues the business. An EBITDA multiple applied to SDE overstates it, because SDE has not yet paid anyone to run the company. The IBBA makes the same point: selecting the proper level of earnings "and matching it with the proper conversion factor – discount rate, cap rate or a multiplier – is critical to calculating a reasonable value" (IBBA Q&A).
The same discipline applies after you reach enterprise value. The bridge from enterprise value to equity value, through cash, debt and debt-like items, works the same way whichever measure you start from. My guide to EBITDA multiples and equity value walks through that bridge.
How SBA lenders look at it
If the deal uses an SBA 7(a) loan, the lender's view matters as much as the broker's. Under SBA SOP 50 10 8.1, effective October 1, 2026, the historical debt service coverage ratio for a change of ownership is defined as EBITDA divided by combined debt service after the transaction. The lender may then calculate an adjusted coverage ratio, with justified additions and subtractions that can include seller discretionary expenses and ownership compensation.
Three points follow from the SOP:
- Every adjustment needs written support. The lender must explain why each adjustment is prudent and how the ongoing business supports it. Unsupported adjustments do not count.
- Owner compensation adjustments are tested twice. Changes to ownership compensation must be backed by a global cash flow analysis showing the buyer can still meet personal obligations.
- Larger deals need a quality of earnings report. For initial acquisitions and business expansions with a purchase price of $3 million or more, the lender must obtain a QoE in addition to the business valuation. The QoE must include a Cash Proof and document add-backs, including above- or below-market owner compensation.
The SOP calls for "an independent, experienced financial professional" rather than limiting QoE to one credential, so the SBA allows CFA charterholders to perform QoE work, subject to the lender accepting the provider and scope. My overview of the SBA quality of earnings requirement covers how the threshold works.
Common SDE and EBITDA mistakes
Most disputes over SDE and EBITDA come from a handful of errors:
- Adding back more than one owner. SDE adds back one owner's compensation. If two partners both work in the business, the second partner's role still has to be paid at market rate.
- Forgetting payroll taxes and benefits. A replacement manager costs more than a salary.
- Personal expenses without evidence. A vehicle, phone or travel add-back needs records showing it was personal and will stop after closing.
- Below-market owner pay. Some owners pay themselves very little. In an S corporation, the IRS expects reasonable compensation for shareholder-employees who provide services. If the owner was underpaid, EBITDA is overstated until a market-rate replacement cost is deducted.
- Recurring costs labeled one-time. A "nonrecurring" repair that happens every year is a recurring cost.
My guide to EBITDA add-backs goes deeper on evidence, and the free EBITDA add-back tester lets you check each proposed adjustment.
How a quality of earnings review tests both measures
A quality of earnings review does not pick SDE or EBITDA for you. It tests whether the earnings behind either figure are real, recurring and supported. That means reconciling the financial statements to tax returns and bank activity, examining each add-back, assessing customer concentration and checking whether margins should hold after the sale. The output is a normalized earnings figure that a buyer, a seller and a lender can all examine.
For sellers, running this work before going to market means the SDE or EBITDA in the listing survives diligence. For buyers, it means the multiple is applied to earnings that actually exist.
FAQ
Is SDE always higher than EBITDA?
Usually, because SDE adds back the owner's full compensation. In a business where the owner draws little or no pay, the gap narrows, and adjusted EBITDA can fall below reported EBITDA once a market-rate manager is deducted.
Which measure should I use to value my business?
Use the measure your likely buyer will use. Owner-operator businesses sold to individual buyers are commonly priced on SDE. Businesses with a management team, sold to funds or strategic buyers, are commonly priced on adjusted EBITDA.
Do SBA lenders use SDE?
The SOP's historical coverage test starts from EBITDA. Lenders can then make documented adjustments, including seller discretionary expenses and owner compensation, so a well-supported SDE analysis still helps.
Can a CFA charterholder prepare the quality of earnings report?
Yes. The SBA calls for an independent, experienced financial professional rather than a single credential, and the lender decides whether to accept the provider.
Next step
If you are weighing an offer or preparing to sell, start by rebuilding SDE and adjusted EBITDA from the same records and comparing each to the multiple on the table. If you want a second set of eyes on the numbers, you can book a call.