Understanding Add-Backs When Selling a Business

What is an Add-Back? Understanding Adjusted EBITDA

Use Add-Backs for a Business Valuation to Derive the Seller’s Discretionary Earnings SDE

What are Adjustments to Income or Normalized EBITA, including interest expenses?

When selling your business, EBITDA add-backs help buyers understand the true profitability of your business and provide a clearer picture of the company’s earnings. These add-backs are expenses that the current owners paid but will no longer exist under new ownership. They are expenses that are 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 evaluating a business, which is a dynamic process that helps assess the company’s operating profitability and actual value of companies, the business valuation process will evaluate add-backs or discretionary expenses.

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 profitability measure. It represents the cash profit generated by the company’s operations, as it excludes non-cash expenses, taxes, and debt costs dependent on the capital structure.

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 expense from a company’s profit and loss statement that a new owner could benefit from. Financial and investment professionals use these add-backs to assess the true profitability and value of a business. Profits, owner’s salaries, and 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 if there has been under-investment in Capex (capital expenditures).

Add-backs and adjustments aim to show buyers and sellers the business’s true earnings by adjusting EBITDA or earnings before interest, taxes, depreciation, and amortization. Cash flow is calculated as net income plus add-backs minus adjustments. An EBITDA multiple is only applicable when comparing similar businesses.

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 to improve cash flow?

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.

Investment professionals operating in the lower-middle market rely on these adjustments to accurately assess a company’s profitability and value.

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.

Types of Add-Backs

Add-backs can be categorized into several types, each serving a unique purpose in presenting a clearer picture of a company’s financial health. Understanding these categories can help business owners and financial professionals make more informed decisions during the valuation process.

1. Discretionary Expenses: These are costs that are not essential to the core operations of the business. Examples include charitable donations, entertainment expenses, and personal expenses of the business owner. By adding these back, you can show potential buyers the true profitability of the business without these non-essential costs.

2. Non-Recurring Expenses: These are one-time expenses that are unlikely to happen again in the future. Examples include litigation expenses, restructuring costs, or one-time settlements. Adding these back helps to normalize earnings and present a more accurate picture of ongoing profitability.

3. Interest Expenses: These are costs related to debt financing, such as interest on loans or credit cards. Since these expenses are tied to the current owner’s financing decisions, they can be added back to show the business’s earnings potential without the burden of existing debt.

4. Amortization Expenses: These expenses relate to the depreciation of intangible assets like patents, trademarks, or copyrights. By adding back amortization expenses, you can highlight the cash flow generated by the business’s operations, excluding non-cash charges.

5. Operating Expenses: These are the day-to-day costs of running the business, such as rent, utilities, and salaries. While not all operating expenses can be added back, certain non-essential or inflated costs can be adjusted to reflect a more accurate operating profitability.

By categorizing and understanding these add-backs, you can present a more accurate and attractive financial picture to potential buyers or investors.

How Add-Backs Impact Business Valuation

Add-backs play a crucial role in business valuation by providing a clearer and more accurate representation of a company’s earnings and cash flow. By adjusting for non-recurring or discretionary expenses, business owners can demonstrate the true profitability of their business, which can significantly impact its valuation.

1. Increase Cash Flow: By adding back non-cash expenses such as depreciation and amortization, business owners can show a higher cash flow. This is particularly attractive to potential buyers or investors who are interested in the liquidity and operational efficiency of the business.

2. Improve EBITDA: Add-backs can enhance a company’s EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) by removing non-recurring or discretionary expenses. A higher EBITDA indicates better operating profitability, making the business more appealing to potential buyers or investors.

3. Enhance Business Value: By providing a more accurate picture of a company’s earnings and cash flow, add-backs can lead to a higher business valuation. This, in turn, can result in a better sale price and more favorable terms during negotiations.

In summary, add-backs help to present a more realistic and attractive financial profile, which can enhance the perceived value of the business and lead to a more successful sale.

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 maximize your business value while minimizing risk by accurately representing your add-backs.

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, including personal expenses?

• Owner’s Compensation

Successful business owners often allocate higher salaries or increased bonuses to themselves instead of ordinary yearly capital expenditures. While this may not pose a problem for the business, new owners can exclude these additional costs from the overall profit.

In some cases, the market demands that the business pay a higher owner compensation to a spouse or family members. In these situations, the business can also add back the difference in cost.

• 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. You can add back these costs, as they are not regular costs. One-time professional fees like business valuations, CPA’s work on your exit strategy, legal fees, litigation expenses, and business broker fees are legitimate one-time add-backs.

You can add back your cost of business valuation and your accounting expenses to your SDE, too.

• How the owner decides to spend and expense profits

The former owner of the company may have made various business expenses, including a company car, sponsorships, life insurance, entertainment, and other expenses that a new owner may not consider essential.

Also, read our article about what is my business worth and how you can increase your business value.

• Differences in compensation

Sometimes, the company may hire a family member and pay them a higher salary than usual. If the company replaces them, they can hire someone for less pay, increasing profit and considered an add-back.

• Interest expenses from loans

The decision to apply for a loan is up to the business owner. Consider late payment interest as an add-back. Add back interest, taxes, and depreciation. If the sale does not include real estate, add back only the interest, not the principal payment.

• Severance and lawsuit settlements

The company can treat this as an expense that reduces net earnings since such payments are uncommon for the company. Non-recurring bad debt can also be an add-back.

• Personal expenses

Personal expenses include non-business-related purchases made by the owner using business profits, which are coded to an SG&A account. Expenses of this nature can be considered add-backs.

• Unexpected weather-related damage

Natural events like storms, fires, and earthquakes can be considered add-backs since they are unlikely to occur regularly. COVID is an example.

Read our short guide on choosing a business valuation company.

• Operating Expenses

While not all operating expenses can be added back, certain non-essential or inflated costs, such as below-market rent expense, can be adjusted to reflect a more accurate operating profitability.

What are examples of non-legitimate types of add-backs?

Income statements should not list recurring expenses as “one-time expenses”, and we cannot automatically consider them as add-back expenses. The same rule applies to potential add-backs after a business acquisition – we cannot include them in the EBITDA calculation during a sale.

Also read: obtain a company valuation before you sell your business to get the best EBITDA multiple.

How can one support considering an expense as an add-back?

When arguing for an expense to be considered an add-back, several factors should be taken into account to ensure its legitimacy.

• Be able to identify and show the actual amount on the tax return or financial statement source document.

• Business owners often make the mistake of finding add-backs on the profit and loss statement or the income statement, rather than the balance sheet. 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.”

• Collaborate 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.

Best Practices for Using Add-Backs

When incorporating add-backs into your financial statements, it’s essential to follow best practices to ensure accuracy and defensibility. Here are some key guidelines to keep in mind:

1. Document Everything: Maintain detailed records of all add-backs, including receipts, invoices, and bank statements. Proper documentation is crucial for substantiating your claims and building trust with potential buyers or investors.

2. Be Conservative: Only add back expenses that are genuinely non-recurring or discretionary. Avoid inflating add-backs to artificially boost earnings, as this can lead to mistrust and potential legal issues.

3. Use Industry Standards: Refer to industry standards and benchmarks to determine what expenses are typical for your business and which can be legitimately added back. This helps to ensure that your add-backs are reasonable and justifiable.

4. Get Professional Advice: Consult with a financial advisor or accountant to verify that your add-backs are accurate and defensible. Professional guidance can help you navigate complex financial scenarios and avoid common pitfalls.

5. Disclose Add-Backs: Clearly disclose all add-backs in your financial statements and provide detailed explanations for each one. Transparency is key to building credibility and trust with potential buyers or investors.

By following these best practices, you can effectively use add-backs to present a more accurate and attractive financial picture, ultimately enhancing the value 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.

As a business owner, do you need help with your business valuation steps, or what makes up a business valuation? Please call or contact BA FL|GA|HI.