SDE, EBITDA, and ARR are the three earnings metrics that buyers use to value businesses. They are not interchangeable. Each applies to a different type of business, measures earnings differently, and produces a different dollar value even from the same set of financial statements. Using the wrong metric — in either direction — means you are either overpricing your business (which kills deals) or undervaluing it (which costs you money).
Understanding which metric applies to your business, and how to calculate it correctly, is the single most important financial literacy task for any seller. This guide covers all three in detail, with calculation examples, decision criteria, and a reference table by business type.
SDE: Seller's Discretionary Earnings
SDE represents the total economic benefit a business delivers to a single full-time working owner. It starts with net income and adds back every dollar that flows to the owner — salary, distributions, personal expenses run through the business, perks — plus non-cash charges (depreciation, amortization) and non-recurring or one-time items. The result is a clean number representing what a new owner-operator would earn working in the business full-time.
How to Calculate SDE
SDE Calculation Formula
Example: Home Services Business
What Counts as an Add-Back?
Add-backs are the most contested part of any business valuation. Legitimate add-backs include: the owner's total compensation (salary, payroll taxes on that salary, distributions), personal expenses that benefit the owner personally rather than the business (personal vehicle, cell phone, travel, meals above normal business entertainment), depreciation and amortization (non-cash charges), interest expense on debt that will not transfer to the buyer, and genuinely non-recurring expenses like a one-time legal defense, equipment replacement, or facility repair.
Illegitimate add-backs — ones sophisticated buyers will reject — include: normal business expenses mischaracterized as personal, expenses that recur annually under different line items, employee costs for functions the owner performs (these get added back but then the cost of a replacement manager is subtracted), and investment in growth initiatives that are ongoing rather than one-time.
The SDE Only-One-Owner Rule
SDE adds back compensation for ONE owner-operator. If two owners work full-time in the business, only one owner's compensation is added back — the second owner's salary represents a real labor cost that a new owner would need to replace. This is a common error that overstates SDE by tens of thousands of dollars and damages seller credibility in due diligence.
EBITDA: For Businesses with Professional Management
EBITDA measures what a business earns independent of its ownership structure, financing, and non-cash accounting charges. Unlike SDE, EBITDA does NOT add back owner compensation — instead, it assumes a market-rate management cost is already baked in. If the owner takes a $200,000 salary, that salary remains as an expense; if the owner takes an unreasonably high salary of $600,000, EBITDA normalizes it to what a market-rate CEO would cost (perhaps $150,000), and the excess is treated as a distribution.
How to Calculate EBITDA
EBITDA Calculation Formula
Example: Professional Services Firm ($4M Revenue)
SDE vs. EBITDA: The Key Difference Illustrated
The same business can produce very different values depending on which metric is used. Consider a business with $2 million in revenue where the owner takes $250,000 in total compensation:
| Metric | Owner Comp Treatment | Earnings Result | At 3.5x Multiple |
|---|---|---|---|
| SDE | Added back in full ($250K) | $480,000 | $1,680,000 |
| EBITDA | Normalized to $120K market rate; excess $130K added | $360,000 | $1,260,000 |
The same business, same financials, same multiple: a $420,000 difference based purely on which metric is applied. This is why buyers of larger businesses prefer EBITDA (it produces a lower earnings figure and thus a lower price), and sellers of those same businesses sometimes push for SDE framing. The market convention matters: if you are selling a $3 million business, expect buyers to use EBITDA. Pushing SDE at that size will damage your credibility.
ARR: For SaaS and Subscription Businesses
ARR is not an earnings metric — it is a revenue metric. It measures the annualized value of all active recurring subscriptions or contracts at a given point in time. ARR-based valuation is used for businesses where the predictability of future revenue is more relevant than current-period profitability, typically because the business is investing in growth and deliberately sacrificing near-term margin for future ARR.
How ARR Is Calculated
ARR Calculation
What Drives ARR Multiples
ARR multiples range from 1x to 8x or higher, and the range is driven primarily by four factors:
- Growth rate: A SaaS business growing ARR at 50% annually commands a dramatically higher multiple than one growing 5%. Buyers are pricing future ARR, not current ARR.
- Net Revenue Retention (NRR): NRR above 100% means existing customers are expanding faster than churning — the business grows without adding any new customers. This is the single highest-value signal in SaaS. NRR above 110% commands top multiples.
- Gross margin: High gross margin (above 70% for software) indicates the business is highly scalable. A SaaS business with 80% gross margins is worth more than one with 50% margins at the same ARR.
- Customer churn: Monthly logo churn above 3% signals a product that does not retain customers — buyers discount heavily for high churn.
| ARR Growth Rate | NRR | Typical Multiple Range |
|---|---|---|
| Declining or flat | Below 90% | 1x – 2x ARR |
| 0–15% growth | 90–100% | 2x – 3.5x ARR |
| 15–30% growth | 100–110% | 3x – 5x ARR |
| 30–60% growth | 110–120% | 5x – 7x ARR |
| Above 60% growth | Above 120% | 7x – 10x+ ARR |
Which Metric Applies to Your Business?
Common Mistakes When Applying These Metrics
Applying SDE to a Business That Should Use EBITDA
Sellers of businesses valued at $4 million or more sometimes push SDE framing because it produces a higher earnings number (by adding back owner compensation). Sophisticated PE buyers and M&A advisors immediately recognize this and will reframe to EBITDA — making you look either naive or intentionally deceptive. Use the market-standard metric for your deal size.
Applying ARR to a Business Without True Recurring Revenue
Not all recurring revenue is the same in buyers' eyes. Month-to-month contracts that customers cancel freely are worth less than multi-year contracts. Usage-based billing that fluctuates with customer activity is not the same as a fixed monthly subscription. Applying aggressive ARR multiples to revenue streams that do not have genuine lock-in will be challenged in diligence.
Not Normalizing Owner Compensation
Owners paying themselves above or below market rate create a distorted picture regardless of which metric is used. An owner taking $50,000 per year who should be earning $150,000 is overstating earnings by $100,000. An owner taking $800,000 in a business that would need a $120,000 manager is understating earnings (for EBITDA purposes) by $680,000. Normalizing to market-rate compensation is standard practice that buyers expect.
Not Sure Which Metric to Use for Your Business?
The Deal Flow Source provides free valuation consultations. We will review your financials, apply the correct metric for your business type and size, and give you an honest, defensible market value range. Licensed Business Broker. No cost to sellers.
Get a Free Valuation Browse Valuation Guides by Business Type