Ask most owners what their business earns and they’ll point to the net income on last year’s statements. Ask a buyer and you’ll get a different number, usually a higher one. Knowing where that gap comes from is the first step to understanding what your business could be worth.
Why your tax return isn’t the starting point
Your financial statements are mostly built to keep your tax bill sensible, not to show a buyer what the business can earn. That’s normal. You pay yourself in the most tax-efficient way, and some personal costs and one-time expenses sit alongside the everyday ones.
None of that is wrong. But it means the profit on paper rarely matches what a new owner would actually take home. So buyers rebuild your earnings from the statements up. This is called normalization, or recasting.
What normalization adds back
Normalization adjusts your reported profit for items that won’t carry on under a new owner. These adjustments are usually called add-backs. Common ones include:
- Owner-specific costs: a vehicle, a family phone plan or travel that’s more personal than business;
- One-time items: a legal settlement, a move to a new building, or a major repair that won’t repeat;
- Non-operating items: interest on a loan the buyer won’t take on, or income from an investment that isn’t part of the business;
- Related-party adjustments: rent paid to a building you own, if it’s above or below what a stranger would charge, or a family member on payroll who doesn’t work in the business.
Adjustments can go the other way, too. If you’ve been paying yourself well below market, or a relative works for free, a buyer will deduct what that work would really cost.
SDE: what the business gives one working owner
Seller’s discretionary earnings, or SDE, measure the total financial benefit the business provides to one full-time owner-operator. You start with pre-tax profit, then add back interest, depreciation and amortization, the add-backs above and the full salary and benefits of one working owner.
SDE is the usual measure for smaller, owner-run businesses. The likely buyer there is often an individual who plans to run the company personally. Their question is simple: how much cash will this give me before I pay myself and the bank?
Adjusted EBITDA: what it earns with a manager in your seat
Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) measures what the business earns no matter who owns it or how it’s financed. The big difference from SDE is how you, the owner, are treated. Instead of adding back your entire pay, it replaces you with the market cost of a manager hired to do your job.
That makes adjusted EBITDA the natural measure for larger companies, for buyers who won’t run the business themselves and for lenders working out how much debt it can carry.
A simple example
Here’s a simplified, hypothetical example of a business that reports $400,000 of net income:
| Item | Amount |
|---|---|
| Net income | $400,000 |
| Add: income taxes | $100,000 |
| Add: interest | $50,000 |
| Add: depreciation and amortization | $100,000 |
| Add: one-time legal settlement | $50,000 |
| Add: personal expenses run through the business | $50,000 |
| Add: owner’s salary and benefits | $250,000 |
| Seller’s discretionary earnings (SDE) | $1,000,000 |
| Less: market salary for a hired manager | ($150,000) |
| Adjusted EBITDA | $850,000 |
Same business, two correct numbers. SDE comes to $1,000,000 because it counts everything one working owner would receive. Adjusted EBITDA comes to $850,000 because a buyer who isn’t running the place has to pay someone $150,000 to do it.
Why the choice changes the multiple
Private businesses are often valued as a multiple of earnings. Because SDE is the bigger number, the multiples buyers apply to SDE are generally lower than those applied to adjusted EBITDA for the same business. Applying an EBITDA-style multiple to SDE is an easy way to end up with an expectation no buyer will meet.
The multiple itself reflects risk: how big the business is, how steady its earnings are, how much it relies on a few customers or on you, and how its industry looks. That’s why two businesses with the same earnings can be worth quite different amounts. Our article on what your business is worth covers those factors in more detail.
When Kingston gives an owner a view of value, we normalize the statements first, use SDE for smaller owner-operated firms and adjusted EBITDA for larger ones, and give a range rather than a single number.
Making your add-backs stand up
Add-backs only help if buyers and lenders accept them. Every one will be tested in due diligence, and any that fall apart at that stage tend to come off the price when you have fewer options.
The ones that hold up usually have a few things in common:
- each is explained in a sentence and backed by a document, such as an invoice, a payroll record or a lease;
- costs that recur aren’t called one-time just because they were high last year;
- the adjusted figures tie back to your financial statements and tax filings;
- the replacement salary reflects what the role would really cost to fill.
A smaller add-back you can prove is worth more than a larger one you can’t.
A good place to start is last year’s general ledger. Sit down with your accountant, flag anything a new owner wouldn’t pay for, and note beside each item why it’s an add-back and where the proof is kept. Do the same each year from now on, and the list will be ready when a buyer asks for it.
General information for business owners and buyers, not financial, legal, tax or accounting advice. Any examples are hypothetical.
