The Seller's Guide to Financial Due Diligence

Buyers write offers on adjusted EBITDA or Seller's Discretionary Earnings (SDE). Lenders fund those offers on defensible SDE - the earnings a credit committee will still accept after add-backs are challenged, tax returns are reconciled, and one-time items are re-classified. The gap between the two is where deals collapse in the final 30 days.

A financing-driven transaction (SBA 7(a), conventional acquisition, seller-financed with lender-required subordination) forces your numbers through an underwriting process regardless of how attractive the buyer thinks the deal is. If the lender says no, the buyer walks or renegotiates hard. Diligence yourself first.

SDE is your net income plus owner compensation, interest, depreciation, amortization, and legitimate one-time or discretionary add-backs. Every one of those additions needs a paper trail. A defensible add-back has three properties:

• Documented. A specific invoice, contract, or journal entry - not a memory of "roughly what we spent on the boat."
• Non-recurring or truly discretionary. If a buyer would have to spend it to run the business, it isn't an add-back.
• Reasonable in magnitude. Aggressive add-backs are the first thing a lender's analyst strips out. Every dollar you can't defend is a dollar off your valuation multiplier.

Build a line-by-line schedule for the trailing three years. For each add-back, note the source document and a one-sentence rationale. When the QoE analyst asks, hand them the schedule - don't scramble for it.

Your internal P&L and your filed federal tax return should tie out cleanly for every year you're presenting. They usually don't. Common gaps:

• Cash-basis tax filings against accrual-basis internals.
• Owner compensation categorized differently in each system.
• Distributions run through operating expenses on the books but treated correctly on the return (or vice versa).
• Depreciation methods that diverge between book and tax without a documented bridge.

Build a reconciliation worksheet - internal net income → reconciling items → tax-return net income - for each of the last three years. This is the single most-requested document in underwriting. Sellers who arrive with it close faster and at higher multiples.

Assume every add-back will be tested. Package each one with the same rigor:

• Owner compensation above market. Attach a defensible market-comp benchmark for a hired replacement in the same role and region.
• Personal expenses run through the business. Auto, phone, travel, meals - categorize each with the specific GL account and the underlying receipts.
• One-time legal, professional, or restructuring costs. Attach the engagement letter or invoice showing the matter is closed.
• Related-party rent or services. Show the contract, the market-rate comparison, and the adjustment.

Underwriting looks at three years of history and asks one question: is this business getting stronger, holding, or slipping? Revenue trend, gross margin trend, and SDE trend are graphed side-by-side. A single dip year with no explanation is a red flag; a dip year with a documented cause (customer loss and win-back, COVID, one-time capital project) is a story the analyst can defend to committee.

Write the narrative yourself. If you don't, the buyer's QoE analyst will - and their version won't favor you.

Financial diligence isn't only about the numbers. Underwriters weight repayment risk based on structural factors that most listings ignore until an LOI is in hand:

• Customer concentration. Any customer above 15% of revenue needs a retention story. Above 25% and the loan structure - or the price - will change.
• Owner dependency. If the business runs on your relationships, your Rolodex, and your daily decisions, transferability is the deal risk. Document delegated responsibilities and key-person backups before you list.
• Supplier concentration and contract terms. Assignability clauses matter. A supply contract that dies on change of control kills the deal financing.

When you're done, you should have a single file - physical or digital data room - with:

• Three years of tax returns.
• Three years of internal financials, reconciled to the returns.
• A trailing-twelve-months P&L, updated monthly.
• The SDE add-back schedule with source documents.
• The tax-to-book reconciliation worksheet.
• A customer, supplier, and key-person concentration summary.
• A one-page narrative explaining any trend anomalies.

This is the same file a buyer's lender will build for themselves - except now you built it first, on your timeline, without a closing date pressing.