The bank sets your salary before you do. Here is the ceiling a 1.25x coverage test puts on it, what is left for tax, and why taking the full amount leaves no margin.
The most an owner can pay himself after an SBA-financed purchase is SDE, less maintenance capex, less the coverage the lender requires on the loan payment. On 600,000 of SDE, 30,000 of capex and 242,883 a year of debt service at 1.25x, the salary ceiling is 266,396. Take all of it and only 60,721 is left in the business, so a 10.1 per cent fall in SDE puts coverage at 1.00x.
Worked in full in Buying a Small Business by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Seller's discretionary earnings are stated before any pay for the owner. That is why a business with 600,000 of SDE can look like a 600,000 income to a first-time buyer. Once there is acquisition debt, three claims come before the owner: the equipment that keeps the business running, the loan payment, and a margin the lender insists on above the loan payment. What is left is the salary the coverage test allows, and many lenders test it again every year from the borrower's financial statements.
| Item | Value |
|---|---|
| SDE, before any owner salary | 600,000 |
| Purchase price, 3.0x SDE | 1,800,000 |
| SBA 7(a) loan, including the financed fee | 1,500,000 |
| Interest rate, term | 10.5%, 10 years |
| Seller note, on full standby | 150,000 |
| Maintenance capex | 30,000 |
| Required debt service coverage | 1.25x |
Monthly payment = 1,500,000 × r / (1 − (1 + r)−120), with r = 10.5% / 12
= 20,240 a month, 242,883 a year
Excel: =PMT(10.5%/12, 120, -1500000)*12
The derivation, with the guaranty fee folded into the loan, is in the monthly payment on an SBA loan.
Coverage is cash flow available for debt service over debt service. The owner's salary is an expense in that cash flow, so solve for it:
(SDE − capex − salary) / debt service ≥ 1.25
Salary ≤ SDE − capex − 1.25 × debt service
= 600,000 − 30,000 − 1.25 × 242,883 = 600,000 − 30,000 − 303,604 = 266,396
Excel: =SDE-Capex-1.25*PMT(rate/12,n,-Loan)*12
Lenders differ on the details: some also deduct the owner's personal tax or a minimum living allowance, some use EBITDA rather than SDE less capex. The structure is the same; only the deductions change.
At the ceiling, the business keeps 60,721 after salary, capex and the loan: exactly the 0.25 times debt service the test asks for. It is not free cash. In a pass-through entity the owner pays tax on the business profit, and the profit is not the cushion:
| Item | Amount |
|---|---|
| SDE | 600,000 |
| Less salary | −266,396 |
| Less interest, year 1 | −153,269 |
| Less goodwill amortisation, 1,440,000 over 15 years | −96,000 |
| Less depreciation | −30,000 |
| Taxable business profit | 54,335 |
| Tax at an illustrative 30% | 16,301 |
| Cushion after that tax | 44,420 |
The goodwill line assumes 80 per cent of the price is allocated to goodwill, amortised over 15 years for tax. The 89,614 of principal repaid in year 1 is not deductible; here the goodwill amortisation shelters it. That shelter is what keeps the cushion positive, and it is worth checking in your own case before you set the salary, because the salary itself is taxed again on your personal return.
| Owner salary | Cash for debt service | DSCR |
|---|---|---|
| 150,000 | 420,000 | 1.73x |
| 200,000 | 370,000 | 1.52x |
| 250,000 | 320,000 | 1.32x |
| 266,396 | 303,604 | 1.25x |
| 300,000 | 270,000 | 1.11x |
| 350,000 | 220,000 | 0.91x |
Now move the earnings instead. If SDE comes in 10 per cent lower, at 540,000, the ceiling falls to 206,396, and an owner already paying himself 266,396 is at 1.00x: every dollar the business earns goes to the bank and to his salary. At 20 per cent lower, 480,000 of SDE, coverage at the same salary is 0.76x and the shortfall comes out of savings.
The seller note matters only when it pays. On full standby it is outside the test. If the 150,000 note amortised over five years at 6 per cent, its 35,609 a year would need the same 1.25x cover, and the ceiling would drop by 44,512 to 221,884.
Setting the salary from the lender's approval. The approval shows that the business covered the loan in the past, under the seller, at a salary the lender assumed. Year 1 is run by a new owner who has not yet proved the earnings, and a buyer who budgets his household on the full 266,396 has fixed his coverage at the covenant from the first month. A salary set nearer 200,000 keeps 1.52x and absorbs a 10 per cent dip in SDE with room to spare. The book's own case makes the same point the other way: the free workbook for this case shows a deal the bank approved at 1.56 times that covered its own debt 0.96 times in year 1 once capex and tax were paid.
Yes. Lenders deduct a salary for the owner-operator before measuring debt coverage, because the business must pay someone to run it. In the worked case each extra 50,000 of salary costs about 0.21x of coverage: 200,000 leaves 1.52x, 250,000 leaves 1.32x, and 300,000 falls to 1.11x, below the 1.25x the case assumes.
Only if it is paying. On full standby it costs nothing in the coverage test. If the 150,000 note in the worked case amortised over five years at 6 per cent instead, its 35,609 a year would need 1.25 times cover, and the salary ceiling would fall from 266,396 to 221,884.
No. SDE is before your salary, the debt, capex and tax. On 600,000 of SDE the worked case pays 242,883 of debt service and 30,000 of capex, so the most that can reach the owner before any tax, leaving coverage at exactly 1.00x, is 327,117, and the lender's 1.25x test stops the salary at 266,396.
This article is one calculation from Buying a Small Business. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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