The asking price is a multiple of a recast number.

The number under the multiple is not profit. It is seller’s discretionary earnings: reported profit plus owner compensation, plus owner perquisites run through the business, plus non-recurring items, plus interest, taxes, depreciation and amortization. Every dollar added back is multiplied into the asking price. Test each add-back against a filed return or the ledger before you argue about the multiple.

How is seller’s discretionary earnings built out of reported profit?

Seller’s discretionary earnings begins with net income on the filed business tax return and adds back what exists only because this owner ran this business: owner compensation, owner perquisites, genuinely one-time costs, and then interest, taxes, depreciation and amortization. The result is meant to represent total cash available to one working owner.

The build is arithmetic, and you can reproduce it. Here is the kind of schedule that sits in the memorandum, with the source document for each line.

Form 1125-E is the corporate return’s schedule of officer compensation. It must be attached where the entity has total receipts of $500,000 or more and deducts officer compensation, and its total carries to the officer compensation line on the face of the return. It is the first place to check whether the compensation add-back matches what was actually deducted. A partnership return or a Schedule C deducts no officer compensation at all; there the owner’s pay is a draw and the add-back ties to the payroll register.

Source: IRS Instructions for Form 1120-S and Form 1125-E, Compensation of Officers.

Why does one dollar of add-backs change the asking price by several dollars?

At a stated multiple, the add-back schedule is a pricing document. On the build above, a 3.25 multiple produces an asking price of $1,706,250. Every $10,000 of add-back carries $32,500 of price. The $38,000 of owner perquisites alone accounts for $123,500. That is why the schedule is the most contested page in the package.

Run the sensitivity before you negotiate. If $60,000 of the schedule fails inspection, the supportable price at the same multiple falls by $195,000. You have not moved the multiple. You have corrected the number the multiple multiplies, which is a different argument, made with documents rather than opinion.

The schedule is not an accounting exercise. At a stated multiple it is a pricing instrument, and it was drafted by the other side.

Which add-backs are defensible, and which are inflation?

A defensible add-back is an expense that genuinely stops at closing, or that never reflected the cost of running the business at all. An inflated add-back is an expense that will reappear on your income statement under a different name. The distinction is not about the seller’s honesty. It is about what happens after the wire clears.

• Owner compensation. Adding back all of it is defensible only where the owner is genuinely absentee. If that person is you, your pay competes with the loan payment for the same cash. If the owner works fifty hours a week in operations, the honest add-back is the difference between what the owner took and what a manager would cost.
• Perquisites. The vehicle, the phone, the family member on payroll who does not work, the travel. These are add-backs only if they stop. If the vehicle carries tools to job sites, it is equipment. If the family member answers the phone, you are hiring a replacement.
• Non-recurring items. One-time means once. A legal fee that has appeared in three consecutive years is a legal budget. Ask for the invoices for the specific event, not a category total.
• Depreciation. Depreciation that stands in for real recurring capital spending is not an add-back at all. In an equipment-heavy business the trucks wear out on your watch. Compare the add-back to actual capital spending over three years from the ledger, not from the schedule.
• Meals and entertainment. Check the return before you credit the number. Entertainment is broadly disallowed, food and beverage expense is generally limited to half, and for amounts paid or incurred after 2025 employer-convenience meals are disallowed as well. A large meals-and-entertainment add-back may not match what was actually deducted.

Law: 26 U.S.C. 274 (disallowance of certain entertainment expenses under section 274(a); 50 percent limit on food and beverage expense under section 274(n); disallowance of employer-convenience meals under section 274(o)). Confirm the rule for the year of the return you are reading.

How do I test the add-back schedule line by line?

Testing an add-back schedule is a documentary exercise with a fixed order: tie the line to a filed return or the general ledger, name the document that proves it, ask whether the expense stops after closing, then subtract a market-rate manager’s salary before you compare multiples across listings. Anything that fails a step comes out.

I read the filed tax return before I read the add-back schedule, and I mark every line on the schedule that has no counterpart on the return.

Two further disciplines. Ask for the schedule in a spreadsheet tied to ledger account numbers, not a PDF of round numbers; round numbers are estimates. And ask the seller to confirm in writing that each expense stops at closing, then put the material ones into the representations in the purchase agreement.

A representation is a claim, not a refund, and it is worth what you can collect: read the survival period, the cap and the basket, and negotiate a setoff right against the seller note. At this size that setoff is usually the only real security. Funded indemnity escrows are uncommon on deals this size, and warranty insurance is rarely economic here, so do not plan around either. An add-back the seller will not stand behind in the agreement is an add-back the seller does not believe.

Will my SBA lender accept the broker’s add-backs?

An SBA lender re-runs the cash flow on its own analysis and is not bound by the broker’s schedule. Stated as of September 2026, SOP 50 10 8 is the operating procedure in force, and SOP 50 10 8.1 applies to applications receiving an SBA loan number on or after October 1, 2026. Confirm the version your lender will apply.

That timing is not academic this month. The rule follows the loan number, not the date you sign the letter of intent. Under SOP 50 10 8.1, debt service coverage is measured at 1.25 to 1 for an initial acquisition and 1.15 to 1 for a business expansion, computed on combined EBITDA over combined post-closing debt service. The measurement period is historical, the last fiscal year end or an average of the last two, and projections cannot be used to clear the floor. Where the business purchase price is $3,000,000 or more, excluding owner-occupied real estate, the lender must obtain an independent quality-of-earnings report and underwrite from its normalized earnings. The report must be commissioned by the lender; one you order does not satisfy it. Under SOP 50 10 8.1 an independent valuation from a qualified source is required on every change-of-ownership acquisition, where under SOP 50 10 8 that turned on a financed intangible portion above $250,000 or a close relationship between the parties. Total transaction debt is capped at the supported business value, so add-backs the valuation will not carry do not become loan proceeds.

Three consequences follow for you, as the rules stand in September 2026. A price supported by add-backs the lender rejects is a price you cannot finance at that leverage, so you fund the difference with your own equity or you renegotiate. The minimum equity injection is at least 10 percent of total project costs, not of the purchase price, and qualifying seller or standby debt counts toward it only on full standby and only up to half of the requirement. A single 7(a) loan is capped at $5,000,000, so above that the balance is equity or seller paper by arithmetic. And holders of at least a 20 percent ownership interest generally must guarantee the loan, which means the schedule you did not test is the schedule you personally guaranteed.

Rule: SOP 50 10 8 (effective June 1, 2025); SOP 50 10 8.1 (SBA Information Notice 5000-880695, effective October 1, 2026, for applications receiving an SBA loan number on or after that date). The SOP is revised periodically; these statements are current as of September 2026, and you should confirm the text in force when your loan number issues.

Law: 13 CFR 120.150 (lending criteria); 13 CFR 120.151 ($5,000,000 maximum for any one 7(a) loan); 13 CFR 120.160(a) (personal guarantees).

Quality-of-earnings work is treated separately by Prencipe International. The point here is narrower: the lender’s normalized number, not the broker’s, sets what the loan can carry.

A price supported by add-backs your lender rejects is not a price. It is a gap, and you fund the gap with your own money.

How do I restate SDE as cash available to service debt and pay me?

Seller’s discretionary earnings is not spendable cash. Convert it by subtracting a market-rate manager’s salary with payroll taxes, then subtracting recurring capital spending, then subtracting the taxes the business or its owner will actually pay. What remains is the cash that must cover debt service and your own compensation. Compare that to the loan payment your lender quotes.

Work the illustrative build backward. SDE of $525,000, less a $110,000 manager package and $45,000 of recurring capital spending, leaves $370,000. Treat that as your own test, not the lender’s ratio; the lender measures coverage on EBITDA before capital spending, so its number reads higher and the two are not interchangeable. If the lender quotes annual debt service of $250,000, your post-capex cash covers that payment about 1.48 times and roughly $120,000 remains before taxes for your own pay. Now remove $60,000 of failed add-backs. The same measure falls toward 1.24 and your residual halves. Same multiple. Different deal.

This is also how you compare listings honestly. Two businesses at the same multiple of SDE are not comparably priced if one needs a $60,000 supervisor and the other a $160,000 licensed operator. Subtract the manager first, recompute the multiple on what is left, then rank the listings.

What should I do before I make the offer?

Rebuilding the add-back schedule from source documents is pre-offer work, not diligence-period work, because it sets the number in your letter of intent. Ask for the filed returns and the general ledger before you propose price, and write the offer against the number you rebuilt rather than the number in the marketing package.

• Request three years of filed returns with all schedules, three years of general ledger detail, the depreciation schedule, the payroll register, the lease, and the add-back schedule in spreadsheet form with ledger account references.
• Rebuild the schedule line by line. Strike anything you cannot tie to a return line or a ledger account, and anything the seller cannot document with an invoice.
• Price a market-rate manager for the role the owner actually performs, using real job postings in that market. Subtract it.
• Compare the depreciation add-back to three years of actual equipment purchases. Subtract recurring replacement spending.
• Send your restated number and schedule to your lender early, and ask which items the credit analysis will accept.
• Confirm which SOP version will govern your file, whether your loan number is likely to issue before or after the change, and whether a quality-of-earnings report and independent valuation will be required at your price.
• Write the offer as a price with the derivation attached, and make the material add-backs representations in the purchase agreement, with a setoff right against the seller note.

Then negotiate the number, not the multiple. The multiple is a convention, and it moves less than the schedule does. The schedule is evidence, and tested evidence is the only part of the asking price genuinely yours to argue.