Valuation · 4 min read · Breakthru Ventures

When you buy a small business, the price is usually expressed as a multiple of earnings. Buyers often argue about the multiple. The bigger risk is the earnings number underneath it. A seller’s figure that includes $150,000 of questionable add-backs, multiplied by three or four, can overstate the price by half a million dollars or more.

This article explains the two earnings measures you will see most often, how to evaluate add-backs and what a quality of earnings review adds.

SDE and EBITDA: two different questions

Seller’s discretionary earnings (SDE) starts with pre-tax profit and adds back interest, depreciation and amortization, one owner’s total compensation and benefits, and discretionary or non-recurring expenses. It answers the question: how much cash does this business generate for one full-time owner-operator before debt service? SDE is common for smaller, owner-operated businesses.

EBITDA (earnings before interest, taxes, depreciation and amortization) is typically adjusted to include a market-rate salary for the manager who will run the business. It answers a different question: what does the business earn after paying someone to run it? EBITDA is more common for larger businesses and for buyers who will not work in the business full time.

The difference matters because multiples are quoted against a specific measure. A multiple of SDE and a multiple of EBITDA are not interchangeable. If a listing quotes SDE and you plan to hire a general manager, subtract a realistic salary before comparing it to EBITDA-based benchmarks.

What an add-back is supposed to be

An add-back is an expense in the historical financial statements that the new owner will not incur. Legitimate add-backs usually fall into a few categories:

• Owner compensation and perks above or outside what the business needs, such as a family member on payroll who does no work or a personal vehicle.
• Truly non-recurring costs, such as a one-time lawsuit settlement or relocation.
• Non-cash charges, such as depreciation and amortization (with an important caveat below).
• Interest on debt that will be paid off at closing.

Each add-back should be supported by documents: invoices, payroll records, bank statements or contracts. If the seller cannot show it, treat it as unproven.

Common add-back problems

Watch for these patterns:

• Recurring “one-time” expenses. If a business has a “non-recurring” repair or legal cost every year, it is a cost of doing business.
• Owner labor that has to be replaced. If the owner works 60 hours a week as the lead salesperson and estimator, adding back their entire salary ignores the cost of replacing that work.
• Deferred maintenance and capital spending. Adding back depreciation is standard, but equipment still wears out. Look at what the business must actually spend on capital expenditures each year to stay competitive.
• Below-market costs that will rise. A below-market lease from a related party, or employees who have not had a raise in years, can mean costs go up after you buy.
• Pro forma savings. Expected cost cuts or price increases are the buyer’s upside. Paying for them in the price means paying the seller for your own future work.

A useful discipline is to sort every add-back into three buckets: verified, plausible but unverified, and rejected. Price the deal on the first bucket and use the second as a negotiating topic.

Normalizing earnings

Normalization goes beyond add-backs. It asks what the business would have earned in a typical year under new ownership. That includes:

• Adjusting owner compensation to a market rate for the role.
• Correcting revenue recognition timing, especially in project-based businesses.
• Reviewing customer concentration, since earnings that depend on one or two customers are riskier.
• Looking at trends across at least three years plus the trailing twelve months, rather than a single strong year.
• Checking working capital, because rising receivables or inventory can make profit look healthier than cash flow.

The result should be a number you can defend to a lender and to yourself.

What a quality of earnings review adds

A quality of earnings (QoE) review is an independent analysis, typically performed by an accounting firm, that tests whether reported earnings are accurate and sustainable. It commonly reconciles financial statements to tax returns and bank deposits, tests revenue and major expenses, evaluates proposed adjustments and analyzes working capital.

A QoE review is not an audit, and its scope varies by provider and budget. For smaller deals, some buyers use a reduced-scope review focused on the riskiest areas. Lenders and investors increasingly expect some form of independent financial diligence, and the findings often feed directly into price and terms negotiations.

Even when you commission a QoE, read the numbers yourself. You are the one who will live with them.

A practical checklist

Before you rely on a seller’s earnings figure:

1. Get three years of tax returns, financial statements and the current year to date.
2. Tie revenue to bank deposits for a sample of months.
3. Request support for every add-back and sort it into verified, plausible and rejected.
4. Subtract the true cost of replacing the owner’s work.
5. Estimate maintenance capital spending and compare it to depreciation.
6. Recalculate the multiple using your normalized number, not the listing’s.

Bottom line

The multiple gets the headlines, but the earnings number decides what you really pay. Treat add-backs as claims to be proven, normalize for how the business will actually run under you, and bring in independent diligence where the risk justifies it.

If you are evaluating a target and want a second set of eyes on the numbers, contact Breakthru Ventures to discuss financial modeling and valuation support.

This article is general information, not financial, accounting, legal or tax advice. Consult licensed professionals about your specific situation.