Most small businesses are run to minimize taxable income, not to show profit. So the number on the tax return is rarely the number a buyer cares about. The buyer wants to know what the business would put in the pocket of one working owner. That figure is seller's discretionary earnings, or SDE, and getting from the tax return to it is called recasting.
What SDE is
SDE starts with reported net income and adds back the things that are not true operating costs for a new owner. The usual categories are the owner's own salary and benefits, interest on debt that will be paid off at closing, depreciation and amortization, and expenses that were personal, discretionary, or one-time.
For larger companies with a management team in place, buyers use EBITDA instead, which does not add back the owner's salary. On owner-operated businesses, SDE is the norm.
Add-backs that hold up
- Owner compensation and payroll taxes on it, when the buyer will take over the owner's role.
- Owner health and life insurance paid by the company.
- Interest on loans that will not transfer.
- Depreciation and amortization, as non-cash charges.
- A documented one-time expense, such as a lawsuit settlement or a relocation.
Add-backs that get challenged
The trouble starts with add-backs that are real costs in disguise. If the owner's spouse does the bookkeeping unpaid, someone will have to be paid to do it. If a "one-time" repair shows up three years running, it is maintenance. If the owner adds back their salary but the buyer plans to hire a manager, the manager's pay comes right back out.
A lender will go through the same list with less patience than a buyer. Add-backs without a paper trail are usually the first thing cut from the lender's version of earnings.
Show the bridge
The most persuasive way to present a recast is as a bridge: reported net income on the left, SDE on the right, and each adjustment as its own step in between, with a one-line reason. It should tie out exactly. If the adjustments do not sum to the difference, the reader stops trusting everything else on the page.
A buyer who can see every step asks better questions sooner. A buyer who is handed one adjusted number has to rebuild the bridge themselves, and they will assume the worst about any piece they cannot find.
This article is general information for brokers and sellers. It is not legal, tax, or financial advice, and practice varies by deal, lender, and state.