What is an Add-Back? Understanding Adjusted EBITDA
Use Add-Backs for a Business Valuation to Derive the Seller’s Discretionary Earnings SDE
Table of contents
- What is an Add-Back? Understanding Adjusted EBITDA
- What are Adjustments to Income or Normalized EBITA?
- Add-backs or Adjustments to EBITDA as Part of the Business Valuation process
- What Is EBITDA?
- What is an EBITDA Add-Back?
- Why would a company want to use business add-backs?
- How do add-backs work in simple terms?
- Can add-backs create a risk to the business seller?
- What are examples of non-legitimate types of add-backs?
- How do you support an expense being considered an add-back?
- M&A Advisory Firms and Private Equity
What are Adjustments to Income or Normalized EBITA?
When selling your business, EBITDA add-backs ensure that your buyers are able to understand the true profitability of your business as accurately as possible. Essentially, business add-backs are expenses that the current owners paid that will disappear under the new ownership, expenses considered unusual, non-recurring, or discretionary.
Add-backs are part of your Seller’s Discretionary Earnings or SDE. Please read our article on what is SDE. The value of your business can increase if we can use your personal expenses in the addbacks and adjustments. The correct EBITDA adjustments with solid proof are critical to your successful exit strategy.
Add-backs or Adjustments to EBITDA as Part of the Business Valuation process
When your business is receiving a business valuation report, a dynamic process that helps assess the actual value of companies, add-backs, or discretionary expenses will be evaluated during the business valuation process.
You will also hear the term normalized EBITDA or adjustments to income to describe the add-backs to the EBITDA process. Your EBITDA calculation should be easy to understand with solid proof.
Read our article what is a business valuation and how add-backs can help increase your company’s value or the value of your business. A business valuation with correctly adjusted EBITDA can help you hold the purchase price.
What Is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income. By stripping out the non-cash expenses like depreciation and amortization as well as taxes and debt costs dependent on the capital structure, EBITDA attempts to represent cash profit generated by the company’s operations.
Because of the personal expenses in entrepreneur-owned businesses, it is important to calculate adjusted EBITDA taking add-backs into consideration.
What is an EBITDA Add-Back?
An add-back is an income or operating expense from a company’s profit and loss statement that a new owner could enjoy the benefits of. Profits plus the owner’s salaries and the owner’s perks make up the total owner’s benefits of the business or the seller’s discretionary earnings SDE.
In addition to add-backs, there are adjustments in the other direction if an owner is underpaid or there has been an under-investment in Capex (capital expenditures).
Add-backs and adjustments are all trying to give buyers and sellers a business’s capacity for “true earnings” by adjusting EBITDA or earnings before interest, taxes, depreciation, and amortization. Cash flow equals net income plus add-backs minus adjustments. An EBITDA multiple only if you are comparing apples to apples.
Gathering your add-backs and a business valuation is all part of your business exit plan as business owners. We will help you calculate the adjusted EBITDA formula.
Why would a company want to use business add-backs?
When selling your business, you want your potential buyer to have the most accurate and holistic picture possible of your true operating expenses, cash flows, and profits. Add-backs allow this to occur and often lead to an increase in the valuation of your business.
This will result in a better selling price and make the business more attractive to potential buyers. Add-backs can also provide better comparable analysis and more negotiation leverage, as the actual potential of earnings can allow you to negotiate for the best price.
Net earnings are important when it comes to accounting and taxation purposes for the IRS. However, when dealing with selling your business to a prospective buyer, net earnings most often do not show the full extent of the most accurate potential profits. This is almost always the case when selling a small business.
Understand what a business valuation should cost.
How do add-backs work in simple terms?
Say you have a staffing company, and you’ve been looking to sell your business. With some of the profits you’ve gained from the staffing agency, you’ve been taking trips to Hawaii. You expense these trips as travel and entertainment expenses.
This cost of vacation trips isn’t actually a cost of running your staffing agency, and so when you’re selling your firm, you want to “add back” the money you spent on the discretionary travel as profit. This will allow you to accurately show your potential buyer how much cash flow they can enjoy post-closing.
Also, see our detailed article on the different business valuation methods.
Can add-backs create a risk to the business seller?
When dealing with add-backs, having too many of them may create potential financial risk. It can be possible to overdo and inflate add-backs, misrepresenting the true profits of a business and creating distrust with your buyers.
Because of this, it is important to work with business valuation experts like Business Appraisal Florida. We will ensure that your add-backs are neither overrepresented or underrepresented, creating the maximum value for your business while minimizing any potential risk.
With a certified business valuation by Business Appraisal Florida, we will take our expert strategic and in-depth analysis to calculate EBITDA and review your potential add-backs with the utmost accuracy and transparency, creating the best-selling opportunities for you.
What are some examples of legitimate types of common EBITDA add-backs?
- Owner’s Compensation
In many cases, company owners with successful, profitable businesses will give themselves a higher salary or increased bonuses, not ordinary yearly capital expenditures. Not an implied issue for the business, however, new owners will not be facing these increased costs, so this cost can be added back to the overall profit.
Sometimes a spouse or family members will be paid a higher owner compensation than the market calls for. This difference in cost can be added back, too.
- One-time business expenses
One-time expenses are any expenses that a company has that only occur one time, such as remodeling or marketing promotions. These costs are not considered regular costs and so can be used as an add-back. One-time professional fees like business valuations, CPA’s work on your exit strategy, litigation expenses, and business broker fees are legitimate one-time add-backs.
Your cost of business valuation and your accounting expenses can be added back to your SDE, too.
- How the owner decides to spend and expense profits
The previous owner of the company may make business expenses such as a company car, company sponsorships, life insurance, company entertainment, and other expenses that a new business owner may not deem necessary for the business.
Also, read our article about what is my business worth and how you can increase your business value.
- Differences in compensation
There are some circumstances in which a family member is hired by the company and is paid more than the regular rate for their job. If being replaced, someone with a lower salary can be hired, creating a difference in profit to be considered an add-back.
- Interest expenses from loans
Whether a business chooses to apply for a loan is entirely up to the owner, and so potential interest from late payments can be considered as an add-back. Interest, taxes, and depreciation are all legitimate add-backs. Unless the real estate is part of the sale, only the interest can be added back and not the principal payment.
- Severance and lawsuit settlements
Assuming payments of these types are not common for the company, this can be considered an expense that goes back to the net earnings. Non-recurring bad debt can also be an add-back.
- Personal expenses
Personal expenses include anything that the owner spent business profits on that was non-business related and coded to an SG&A account. Expenses of this nature can be considered add-backs.
- Unexpected weather-related damage
Unexpected issues caused by natural events such as storm damage, fire, and earthquakes can be considered as an add-back because they are unlikely to happen on a regular basis. COVID is an example.
What are examples of non-legitimate types of add-backs?
“One-time expenses” that appear on an income statement year after year cannot be considered actual one-time expenses and so cannot be inherently considered an add-back expense, depending on the recurring expenses themselves. Additionally, potential add-backs that may occur after the business is purchased cannot be considered as an add-back in the EBITDA calculation when selling.
Also read: obtain a company valuation before you sell your business to get the best EBITDA multiple.
How do you support an expense being considered an add-back?
When making a case for an expense being considered an add-back, there are a few things to be considered to ensure legitimacy.
- Be able to identify and show the actual amount on the tax return or financial statement source document.
- Add-backs are found on the profit and loss statement or the income statement, not on the balance sheet. Many business owners make that mistake. Disbursements come out of profits that have already been “booked.” If an expense wasn’t a P&L line item, then it cannot be “added back.”
- Work with your CPA to potentially generate a General Ledger Report that contains the details on the expenses for the add-back being used.
- Be able to explain and justify why this cost will not occur for the new business owner.
- Accrual accounting may show your business in a better light than cash-based accounting. Look at your financials both ways to get the best picture of your business.
M&A Advisory Firms and Private Equity
Are you using an M & A advisory firm? We take the EBITDA adjustments and do business valuations for private equity, SBA lenders, and M&A advisory firms.