Say a business owner runs a $1.2 million pest control company. He opens his tax return, finds net profit of $180,000, and does the math on what that’s worth.
At a 2.5x multiple, that’s $450,000. After 14 years of 6 a.m. starts, it feels light.
Here’s the thing. He’s probably looking at the wrong number.
The number buyers use is called seller’s discretionary earnings, or SDE. It’s what the business earns for one owner-operator before the owner’s pay and before the expenses that exist because of how the owner runs the company. And for this owner, that number is closer to $400,000.
Nothing is hidden or unreported. It’s sitting in his P&L, and he just hasn’t been shown how to read it.
Where the other $220,000 comes from
A tax return is built to minimize taxable income. A buyer’s valuation is built to measure what the business actually earns. Those are two different jobs, so they produce two different numbers.
The bridge between them is add-backs, which are expenses on the P&L that a new owner wouldn’t have to pay, or that don’t reflect how the business really operates. Most owners have never heard the term. They assume what the return says is what the business makes.
Here’s how this owner’s $180,000 turns into $400,000:
- Net profit on the return: $180,000
- Owner’s salary: $110,000. The buyer is stepping into that seat and taking the profit as their own pay, so it comes back.
- Depreciation: $26,000. It’s a tax deduction, not cash leaving the business.
- Interest: $9,000. It depends on how the current owner financed things.
- Owner’s health insurance: $14,000
- Truck the owner also drives to the lake house: $18,000 of personal use
- Spouse on payroll for light bookkeeping: $24,000 above what the job would cost to hire out
- One-time legal bill from a lease dispute that’s settled: $12,000
- Personal travel and meals run through the business: $7,000
Total add-backs: $220,000. Total SDE: $400,000.
At the same 2.5x, the business is worth $1,000,000, not $450,000.
That’s a $550,000 difference, and the only thing that changed was how the same numbers were read.
The catch: every add-back has to survive a buyer’s scrutiny
Now for the uncomfortable part. Learning about add-backs is the easy half. The harder half is that every one of them has to be defended.
Owners who discover this concept tend to overdo it. They start labeling anything they can rationalize as “discretionary,” treating add-backs as a way to push SDE as high as it will go. Then a buyer lays three years of financials side by side and the story stops adding up.
A buyer financing the purchase with an SBA loan also has a lender in the room. Lenders verify tax returns directly with the IRS using Form 4506-C, so every add-back has to tie back to something that really appears on the return, with a bank statement, invoice, or payroll record behind it.
The depreciation and interest add-backs are rarely contested, since both are standard and easy to trace. (The IRS’s guide to depreciation lays out how those deductions work.) The questions come on the soft ones. The spouse’s payroll is only an add-back if the work is genuinely light and the buyer doesn’t need to replace it. The truck is only an add-back for the personal-use portion. And a “one-time” legal bill that appears in three straight years isn’t one-time.
Defensible add-backs get paid for. Aggressive ones cost you credibility, and credibility is the thing you’re negotiating with.
What to do before you list
Pull your last three years of tax returns and P&Ls and read them the way a buyer would. Go line by line and ask, “Would a new owner still have to pay this?” Mark each answer, with paperwork, and total it up.
Then look at the trend. A business with $400,000 in SDE this year, $390,000 last year, and $410,000 the year before is a business a buyer can underwrite. One that jumps $150,000 in a single year invites questions you’ll have to answer.
If you’re two or three years from selling, there’s even more room to work. Run personal expenses through personal accounts, keep the books clean enough that nothing needs explaining, and have your CPA flag which expenses will be add-backs down the road. IRS Publication 535 covers which business expenses are deductible, and a CPA can tell you which of yours a buyer will treat as the owner’s rather than the business’s.
The takeaway
Your tax return tells the IRS what you owe. It doesn’t tell a buyer what your business earns.
For most owner-operated companies, the gap between the two is real, it’s often six figures, and it’s worth hundreds of thousands at closing. Owners who learn to read their own P&L before a buyer does tend to price their business correctly, defend it better, and avoid the sinking feeling of seeing an offer based on the wrong number.
Curious what your business is worth once the add-backs are done right? Reach out to The Turn Business Advisors for a confidential conversation. No pressure, and no obligation to list.