Add-Backs Buyers Accept (And Those They Don’t)

Add-backs are adjustments made to a company’s earnings to reflect a more accurate picture of its ongoing profitability. These adjustments are intended to exclude discretionary expenses that are not necessary to run the business.

Tax Returns are designed to minimize tax liabilities for the business owner, but not necessarily to reflect the true profitability or cash flow of a company.

By normalizing the company’s financials, the business owner can prove to a buyer what the business would look like free of personal or one-time expenses. However, there is a fine line between an acceptable adjustment and an overly aggressive approach.

Because businesses are sold on a multiple of earnings, every dollar in EBITDA add-backs will result in an increase of the sale price. If the business, for example, is valued at a 4x multiple, finding $100,000 in acceptable add-backs will add $400,000 to the sale price.

Understanding how to get to an adjusted EBITDA is essential for any exit strategy to maximize the return for the business owner.

1. EBT (Earnings Before Tax) from the Tax Return
2. + Owners Salary (if not distribution)
3. + Owners Benefits (cars, travel, perks, etc.)
4. + Non-Working (or overpaid) Family Members
5. + Depreciation & Amortization Expense
6. + Interest Expense
7. +/- Rent Adjustments (over / under)
8. + Any Unusual or One-Time Expenses
9. = Seller Discretionary Cash Flow
10. – Normalized Manager Salary
11. = EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization)

As most buyers in the lower middle market require a quality of earnings report before closing, it is imperative to have all documentation in place to fully defend each add back. The QoE analyst will request bank statements, invoices and payroll records to reconstruct the add backs. The Analyst will check if expenses marked as one-time or non-recurring have only occurred in one year and aren’t necessary to run the business. They will also check the normalized owner compensation based on market data or compensation surveys.

If an add-back fails the QoE review, the buyer most likely will request an adjustment to the asking price. If too many add-backs fail, the seller might damage credibility and the buyer might walk away from the deal.

If a seller is thinking about an exit strategy, it is recommended to work with an experienced M&A advisor to identify defendable add-backs by putting a 3^rd party, independent valuation in place to allow the seller to walk away from the business with the best possible outcome.