As a business owner, you’ve likely heard of “add backs” when it comes to selling your business.
But what exactly are they, and why do they matter?
In this post, I’ll give you everything you need to know about add backs and answer common FAQs as you navigate the process of selling your business.
What are add backs in a business sale?
In short, add backs are adjustments made to a company’s financials that increase its profitability. When selling a company, these are expenses that are classified as non-recurring, discretionary, or unusual.
These adjustments can include things like owner’s compensation, personal expenses, and one-time costs that aren’t representative of the company’s ongoing expenses.
By adding back these costs, the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) will be higher, making the business appear more profitable and therefore more valuable.
Why add backs matter
Why does this matter as a company owner when selling your business?
Simply put: buyers want to see a profitable company. By including add backs in your financials, you’ll be able to show a more attractive EBITDA, which will increase the perceived value of your business and therefore the price that buyers are willing to pay for it.
This makes the company’s earnings appear higher and increases its overall value.
But here’s the catch: add backs can be a double-edged sword. On one hand, they can help you get a higher price for your business. On the other hand, if they’re not handled correctly, they can raise red flags for a potential buyer and make them question the legitimacy of your financials.
For an accurate valuation, it’s crucial that you handle add backs appropriately.
Types of add backs
Some common types of business related add-backs include:
- Owner compensation: If you, as the business owner, take a salary (i.e. seller’s discretionary earnings) that is higher than what a typical employee in your industry would earn as fair market value, you can add back the difference.
- Family compensation: Similar to the owner compensation, if you have family members working in the business and they are paid more than a typical rate for someone in their role, you can add back the difference.
- Personal expenses: If you use the business’s resources for personal use, such as using the company car for personal use (i.e. travel expenses or entertainment expenses), you can add back those discretionary expenses. Think about any type of expense not related to running the business.
- One time occurrence expenses: One-time expenses, such as legal fees or equipment purchases, that aren’t representative of the company’s ongoing operating expenses can be added back.
- Capital expenditures: These are expenses that are made to improve or maintain the company’s assets, such as buying new equipment or renovating a building.
- Depreciation: This is a non-cash expense that can be added back as it reduces the company’s net income.
It’s important to call out that not all add backs are legitimate.
Be sure that the add backs are truly representative of the company’s ongoing expenses and are not just a way to artificially inflate the company’s profitability.
Which expenses can be counted as add backs?
Before you start listing every expense under the sun as an add-back, it’s important to understand that not all expenses qualify. The expenses that can be added back to operating income must be truly discretionary and not necessary for the day-to-day operations of the business.
A few recommendations:
- Don’t include personal expenses or one-time costs that have nothing to do with the business: Avoid excessive expenses – you’ll only want to include expenses that are truly representative of the company’s ongoing expenses.
- Be transparent about your add backs: Include them in your financials, but also provide an explanation of what they are and why you’re including them. This will help ease any concerns buyers may have about the legitimacy of your financials.
- Be prepared to negotiate: Prospective buyers may want to adjust the add backs themselves, or they may want to use a different method of valuation altogether. Be open to these discussions and be prepared to defend your add backs if necessary.
How are add backs calculated?
Let’s get tactical and walk through how add backs are calculated.
- Review the business’s financial statements to gain a clear picture of the business’s overall financial health and identify any non-recurring expenses that may qualify as add backs.
- You could also work with a professional with experience in business valuations and sales to review your financials to help you identify any non-recurring expenses that don’t reflect the ongoing operations of the business.
- Document the add backs by providing detailed documentation of the expenses, explaining how they were incurred and why they are being subtracted from the financials.
- Calculate the impact of the add backs on the business’s earning potential by subtracting the identified add backs from the company’s taxable income and recalculating key metrics such as net income or cash flow.
Be honest and realistic about the expenses being subtracted, as misrepresenting or inflating the add backs can damage your credibility and negatively impact the sale process.
Keep in mind that your M&A advisors or lawyer can help you navigate this process.
FAQs about add backs
What are add backs, and why are they important to my business valuation?
Add backs are non-recurring expenses that a seller can subtract from the business’s financials to arrive at a more accurate picture of its true earning power. These expenses can include one-time costs like legal fees, relocation expenses, and non-essential equipment purchases.
By subtracting these expenses, a buyer can get a better understanding of the business’s true earning potential, and the seller can potentially increase the final purchase price.
What types of expenses can be considered add backs?
Some common examples of add backs include legal and professional fees, non-essential equipment purchases, relocation expenses, and the cost of non-recurring promotions or advertising.
Keep in mind that the specific add backs that are applicable will depend on your unique circumstances and the terms of the sale.
How can a business owner determine which expenses qualify?
The best way to determine which expenses qualify as add backs is to work with an M&A advisor with experience in business valuations and exit planning.
They will be able to review your financials and identify any expenses that are non-recurring and do not reflect the ongoing operations of the business.
How do I present add backs to potential buyers?
It’s important to be transparent and clear about the business expenses you’re proposing. The best way to do this is to provide detailed documentation of the expenses, such as invoices or receipts, and to clearly explain how they were incurred and why they are being subtracted from the financials.
Can add backs be used to inflate the purchase price of my business?
While add backs can certainly help to increase the final purchase price, it’s important to be honest and realistic about the expenses being subtracted.
As I mentioned above, misrepresenting or inflating these expenses can hurt your credibility and the chances for a successful sale.
What’s the best way to maximize the value of add backs when selling my business?
The key to maximizing the value of add backs is to have a clear understanding of your business’s financials and to work with a professional who can help you identify and document non-recurring expenses.
As I mentioned above, it’s important to be transparent and honest about the add backs you’re proposing, and to clearly explain how they will impact the business’s earning potential.
Wrap Up
In conclusion, add backs can be a powerful tool when selling a business, but they need to be handled correctly.
Make sure they’re legitimate, be transparent about them with the new owner, and be ready to negotiate.
Remember that they are not a one-size-fits-all solution – everything will depend on the specific circumstances of your business and the terms of the sale.
I hope this post helped clear up a few things for you – feel free to leave a comment below if you have any questions.
