What Is SDE
Seller's Discretionary Earnings (SDE) is the total cash profit a franchise owner can extract from the business in a given year. It starts with net income and adds back owner salary, benefits, discretionary expenses, and non-recurring costs to show what a buyer would actually take home.
For franchise evaluation, SDE matters because the franchisor's Item 19 financial performance representations in the Franchise Disclosure Document (FDD) typically report this metric rather than net profit. A franchise generating $150,000 in net income might have $220,000 in SDE if the owner paid themselves $50,000 and incurred $20,000 in personal vehicle expenses or other discretionary spending.
SDE in Franchise Due Diligence
When reviewing an FDD, Item 19 will often present SDE figures from existing franchisees. These numbers help you project your own earnings potential, but they require careful scrutiny. The franchisor is not required to include all franchisees' data, only those they choose to report. This selection bias means reported SDE figures typically skew higher than the system average.
Calculate SDE by taking the franchisee's reported net income and adding back:
- Owner draw or stated salary
- Owner health insurance and benefits
- Vehicle expenses (depreciation, fuel, maintenance)
- Meals and entertainment that are personal rather than business-critical
- One-time or non-recurring expenses (equipment replacement, lawsuit settlements)
- Franchise fees paid in year one (since future years won't include this cost)
Always ask franchisees during reference calls what their actual SDE looks like after subtracting costs the franchisor didn't disclose or that increased after opening. Territory size, renewal terms, and franchisor support level all affect whether a franchisee's SDE remains stable or declines over time.
SDE and Business Valuation
Most franchise businesses are valued at a multiple of SDE, typically between 2.5 and 4.5 times annual SDE depending on growth trajectory and market conditions. This is how you'd calculate what a buyer might pay for an established franchise unit. If your franchise generates $180,000 in SDE and the market applies a 3.5x multiple, the business is worth roughly $630,000.
Compare SDE to EBITDA, which excludes owner salary entirely. For franchise evaluation, SDE is more relevant because it reflects what you'll actually earn as the owner-operator, while EBITDA is more useful for comparing to national retail or restaurant benchmarks.
Red Flags When Reviewing SDE Claims
- Item 19 shows SDE but the FDD doesn't clearly define what expenses were added back. Request the franchisor's exact calculation methodology.
- SDE figures don't account for territory rights restrictions. If your renewal terms limit you to your original territory, future growth may be capped.
- Reported SDE includes significant franchisor rebates or co-op credits that disappear after your first year.
- The franchisee data is 2+ years old. Ask current franchisees whether actual SDE has held steady or declined due to rising labor costs or increased competition.
Common Questions
Should I trust Item 19 SDE numbers from the FDD?
Item 19 provides a starting point, not a guarantee. The franchisor can include only franchisees who've been open long enough to report results (usually 12 months minimum). They're not required to include underperforming locations. Call at least five referenced franchisees and ask for their actual SDE, tax return net income, and whether their numbers improved, stayed flat, or declined after year one.
How does franchise fees affect my SDE calculation?
Initial franchise fees are a one-time cost in year one. When reviewing Item 19 SDE from existing franchisees, their first-year numbers will be artificially lower because they paid the franchise fee that year. If the fee is $50,000 and you're comparing year-one SDE to year-three SDE, add that fee back to year-one figures for a fair comparison.
What happens to SDE if I renew my franchise?
At renewal, franchisors sometimes increase royalty percentages or require system upgrades that reduce SDE. Review your renewal terms in the FDD before signing. If renewal royalties increase from 5% to 6% on $500,000 in revenue, you lose $5,000 in annual SDE. Territory rights may also shift at renewal, affecting your growth potential and future SDE.