When you're reviewing a deal package, one of the first things to establish is which earnings metric the seller is using to size the business. In lower middle market transactions, you'll encounter two: EBITDA and SDE. They measure related but different things, and applying the wrong valuation framework to either one will produce a purchase price that doesn't reflect economic reality.
The Core Difference
| SDE | EBITDA | |
|---|---|---|
| Full name | Seller's Discretionary Earnings | Earnings Before Interest, Taxes, Depreciation & Amortization |
| What it measures | Total economic benefit to a single owner-operator | Operating earnings assuming a professional management team |
| Typical deal size | Under $1–2M in earnings | $2M+ in earnings |
| Buyer profile | Individual acquirer, owner-operator | PE, independent sponsor, search fund |
| Valuation multiple | 2–4x SDE | 4–8x+ EBITDA |
The key structural difference comes down to owner compensation. In an SDE calculation, the owner's full compensation gets added back entirely — the assumption is that the buyer will step into the owner's role. In an EBITDA calculation, owner compensation is normalized to a market-rate replacement cost, because the buyer is expected to hire professional management rather than operate the business personally.
How to Tell Which Metric Applies
Business size is your first signal. Below roughly $1–2M in annual earnings, SDE is the standard. Above that threshold, you're typically working with EBITDA. But size alone isn't definitive, because structure matters as much as scale.
The more useful question is whether the owner is the business. In a sole-practitioner professional services firm, a single-location restaurant, or an owner-operated trade business, the owner's labor is often the primary driver of revenue. That holds true as an SDE business regardless of top-line size.
If the owner walked out on day one and you had to hire someone to replace everything they do, what would that cost? If the answer is close to the owner's full compensation package, you're looking at an SDE business. If a $120,000 general manager could run day-to-day operations effectively, you're in EBITDA territory.
Why This Matters for Your Underwriting
Getting the metric wrong creates real problems at the offer stage. The most common mistake buyers make is applying an EBITDA multiple to a business that should be valued on SDE, which produces an offer the seller won't take seriously.
Consider a simple example. A plumbing company generates $800,000 in revenue. The owner pays himself $200,000, runs another $50,000 in personal expenses through the business, and the company shows $150,000 in reported net income. Reported EBITDA might be $180,000 after adding back depreciation. But SDE, once you add back the owner's full compensation and personal expenses, is $430,000.
The seller and their broker are pricing this business on SDE. At a 3x multiple, they're expecting somewhere around $1,290,000. If you show up quoting a 4x EBITDA multiple and offer $720,000, that's nearly $570,000 below the seller's expectation — and the gap isn't a negotiating position, it's a methodology mismatch.
Where Addback Analysis Fits In
Both metrics rely on addbacks, but the addback logic differs between them in one important way. In an SDE analysis, the owner's entire compensation is added back. In an EBITDA analysis, owner compensation is normalized: the excess above a market-rate replacement salary is added back, but a reasonable management cost stays in the expense base.
Sellers of larger businesses sometimes present addbacks using SDE-style logic, adding back the owner's full compensation rather than normalizing it. That inflates adjusted EBITDA and, by extension, the purchase price. A thorough Quality of Earnings analysis will flag this.
Watch for metric switching mid-negotiation. Some sellers or their brokers will present one metric in the CIM and shift to another during LOI negotiations when it produces a more favorable number. If the basis for valuation changes between the initial package and the term sheet, ask why — and make sure your QoE anchors the analysis to a consistent methodology before you finalize your offer.
QoEPro provides buy-side Quality of Earnings reports for independent sponsors, search fund entrepreneurs, and private equity buyers in the lower middle market. Our analyses include earnings metric validation and addback consistency review across both SDE and EBITDA frameworks. View report options →