Every buyer has faced the moment: a seller slides over their SDE calculation, and the number feels soft. Add-backs that seem padded. Related-party expenses that blur the line between legitimate add-back and creative accounting. The seller claims $800K in SDE on a $2M revenue business, and your instinct flags that something doesn’t track. The tension between accepting the seller’s narrative and protecting your own capital lies at the heart of acquisition diligence. This guide walks through the specific red flags that should trigger deeper diligence—not to assume fraud, but to separate defensible earnings adjustments from those that won’t hold up to a CPA’s scrutiny or survive post-close operating reality.
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When Discretionary Add-Backs Become Discretionary Accounting
Seller Discretionary Earnings (SDE) is designed to add back owner expenses that won’t recur under new ownership—the owner’s salary, their car, their health insurance, occasional meals and entertainment tied directly to the owner. These are defensible and expected. Red flags emerge not when add-backs exist, but when they stretch credibility or lack supporting documentation.
A common inflection point: the seller claims a six-figure “management fee” to a related entity, or a consulting fee paid to their spouse for unspecified “strategic advisory work,” with no contracts, no timesheets, no clear deliverables. When pressed, the explanation is vague—”well, she helps run the business”—and the amount has shifted year to year without obvious correlation to business growth. In a legitimate add-back calculation, the expense should be specific, documentable, and defensible to a third-party CPA. If the seller can’t produce an employment agreement, an invoice, or detailed time records, that’s a signal to exclude it from your working SDE or to model it as a future recurring cost.
Another pattern: owner-paid expenses that exist in some years but vanish in others, with no explanation. Imagine a service business that claimed $120K in annual “training and professional development” in year one, dropped to $15K in year two, and spiked back to $95K in year three. When asked why, the seller shrugs: “We needed it some years, not others.” That variance isn’t inherently wrong, but it invites scrutiny. Did the business actually need less training in year two, or did the seller defer the expense to make that year look worse? If you’re relying on a multi-year average SDE, one soft year can mask underlying profitability issues. Request detailed invoices, attendance records, or receipts tied to each spike and dip.
Related-Party Transactions and the Paper Trail Test
Related-party expense add-backs—payments to the owner’s family members, entities they control, or friends—deserve your closest scrutiny. These transactions happen outside arm’s-length market discipline, so they’re prone to misstatement, either innocently (loose record-keeping) or intentionally (inflating expenses to reduce tax liability).
The red flag checklist for related-party items:
- No written contract or statement of work. A legitimate related-party arrangement should have terms—even a one-page email agreement is better than nothing. If the seller can’t produce a contract, question whether the expense actually represents the claimed service.
- Expense amounts that don’t scale with business activity. Say the seller pays their spouse $36K per year as a “bookkeeper,” but the business uses third-party accounting software and the spouse’s actual role is ad hoc. If you replaced that arrangement, you’d hire a part-time bookkeeper at $20K. The $36K figure is neither market-rate nor proportionate to work performed—it’s owner salary disguised as an operating expense, which doesn’t belong in SDE.
- Payments in round numbers or irregular cadences. Legitimate vendors invoice monthly, quarterly, or per-deliverable. If a related-party payment arrives as exactly $5K per month regardless of work, or $60K annually split unevenly across quarters, that suggests it’s not tied to actual services rendered.
- No evidence the related party performs the claimed work. Request emails, work product, timesheets, or third-party confirmations that the related entity actually delivered the service. If a “marketing consultant” relative supposedly generated campaign materials, ask to review those materials or contact who received them internally.
Imagine a staffing business where the owner’s brother is paid $50K annually as a “recruitment specialist,” but the business doesn’t actually hire for outside companies—it’s an in-house staffing firm. The brother’s stated role makes no sense given the business model. That’s a red flag that demands either a detailed breakdown of what the brother actually does, or a recommendation to exclude the $50K from SDE because you can’t defend it as a necessary, recurring expense.
The Revenue and Margin Coherence Test
One of the most revealing checks is to sense-check SDE against gross margin and operating expenses. If a business reports high SDE relative to its revenue and margin structure, something may be wrong with the add-back calculation.
Example: a consulting firm with $1.5M in revenue, 60% gross margins, claims $650K in SDE. That’s a 43% SDE margin on revenue—unusually high. Backing out the claimed $250K in owner salary, the business is claiming $400K in other discretionary add-backs (car, insurance, meals, travel, consulting fees to the owner’s sister, etc.). That’s 27% of revenue in total add-backs beyond owner salary. When you map it against their detailed P&L, only $80K of that actually exists on the books—the rest is claimed as “business-related” but never formally expensed. In essence, the seller is asking you to trust that large legitimate business costs are hiding just off the P&L. A CPA would likely reject most of this. Your due diligence should ask: where is the documentation? Which costs are actually incurred, and which are hypothetical?
Conversely, an unusually low SDE relative to revenue can signal that the seller is reserving discretionary add-backs, either to not tip off tax authorities or to manage buyer expectations. If a business with high margins reports minimal add-backs and an SDE figure that feels conservative, that’s not necessarily a red flag—it may be a disciplined owner who documents everything properly. But if the story doesn’t hang together (huge cash flow, minimal reported add-backs, high tax burden), dig into why.
One-Time vs. Recurring: The Story Must Hold
Sellers often claim that certain expenses are “one-time” and shouldn’t recur. Relocation costs, one-off litigation, a one-year spike in repairs due to a single equipment failure—these can be legitimate. The red flag emerges when the “one-time” narrative shifts or when “one-time” costs appear frequently.
Ask directly: Is this cost truly non-recurring, or is it a category that will recur under your ownership? If the seller claims a $75K legal settlement as non-recurring, verify it’s settled and no ongoing liability exists. If they claim software migration costs as one-time, confirm the migration is complete and won’t happen again in year one under new management. If they claim that bad debt writeoff as a one-time event, check the historical bad debt rate—is this actually the first time in five years, or is it the third time they’ve claimed a large “one-time” writeoff?
A concrete check: request a three-year detail of any category claimed as one-time. If “one-time repairs” appear in two of the past three years, or if “one-time litigation costs” recur annually, that’s a red flag that the expense category is structural, not exceptional, and should be excluded from your SDE or reserved as an ongoing cost.
Documentation Red Flags and the CPA Test
The ultimate test: would a licensed CPA accept this add-back? If the answer is “probably not,” exclude it from your SDE calculation. Specifically, red flags include:
- No supporting invoices or receipts. The seller claims $25K in “equipment maintenance” but has no vendor invoices, just a note in QuickBooks with no detail.
- Round-number accruals with no documentation. An entry for “$10K, discretionary travel” with no trip records, credit card statements, or expense reports.
- Intercompany transactions with no supporting documentation. A payment to an affiliate with no explanation of what was purchased or why.
- Estimates or “reasonable approximations” instead of actual expenses. The seller estimates they spent “roughly $15K on owner travel and client entertainment” but kept no receipts. A CPA would demand actual records or exclude it.
Frequently Asked Questions
How aggressive can a seller’s SDE add-backs be before I walk away?
There’s no magic number, but a useful benchmark is that documented, defensible add-backs typically total 15–35% of EBITDA depending on industry and owner involvement. If add-backs exceed 50% of EBITDA, or if more than a third of claimed add-backs lack supporting documentation, you’re in high-risk territory. Don’t assume fraud—the seller may simply be disorganized—but treat undocumented add-backs as non-recurring for your own valuation, and lower your offer accordingly.
Should I exclude add-backs I can’t verify, or model them conservatively?
Exclude them from your base case SDE and create a separate scenario for a more aggressive interpretation. Your offer should be grounded in what you can defend. If the seller claims $200K in defensible add-backs and another $150K in questionable ones, value the business on the $200K figure; if the questionable ones hold up under deeper diligence, that’s upside. Never value a deal on assumptions you can’t document.
What if a seller’s add-backs are unusual but the business is profitable?
Profitability is a different question from the truthfulness of add-back claims. A business can be legitimately profitable with or without owner discretionary expenses. If a business has solid free cash flow and reasonable margins, some discretionary add-backs may not matter to your valuation. But if your offer is anchored to a seller-reported SDE that includes questionable items, you’re taking on risk. Either reduce your offer to account for that risk, or do deeper diligence to separate fact from assertion.
How do I know if a related-party expense is legitimate?
The standard is arm’s-length: would an unrelated third party perform the same service for the same price, or would you pay a market vendor less? Request an invoice, a contract, and evidence of work performed. If the related party is a family member, ask specifically what work they do, how many hours, and provide examples of deliverables. If you can’t get a clear answer, assume the expense is at least partially owner salary in disguise, and exclude a portion of it from SDE.
Can I hire a CPA to review the seller’s SDE before I make an offer?
Absolutely—in fact, for deals over $2–3M, it’s standard practice. For smaller deals, the cost of a full Quality of Earnings engagement may not be justified, but a focused CPA review of high-dollar or questionable add-backs is entirely reasonable. This platform organizes normalized EBITDA and SDE data to help you identify which add-backs warrant that deeper review, so you’re not paying for a CPA to audit every line item—just the ones that matter to your offer.
Red flags in a seller’s SDE calculation require disciplined skepticism, not cynicism. Most sellers are honest; many are simply disorganized. Your job in diligence is to separate defensible earnings from aspirational accounting. Focus your scrutiny on three areas: related-party transactions that lack documentation or market discipline, add-backs that don’t cohere with the business’s revenue and cost structure, and “one-time” expenses that recur or appear excessive. Document everything, create a conservative base case and an aggressive scenario, and always ask a licensed CPA for a second opinion on high-risk items before you commit capital. The difference between a well-defended SDE figure and an inflated one often determines whether you earn money on the deal or lose it in the first year of ownership.
This article is educational and does not constitute M&A, investment, or accounting advice — confirm findings with a licensed CPA or M&A advisor before making an offer.
This article is educational and does not constitute M&A, investment, or accounting advice — confirm findings with a licensed CPA or M&A advisor before making an offer.
For a faster alternative to a traditional QoE engagement, see IncomeReady for M&A Buyers.