So you’ve decided to sell your business. And after years of blood, sweat and tears doing whatever’s necessary to build it into the success it has become, you want to make sure you get absolute top dollar for it.
That’s when the bean counters come in and start to calculate a valuation for your business. Of course the buyer’s financial team is going to try to get them the best deal and keep the valuation low. So chances are they aren’t going to include any potential add-backs in their numbers.
What are “add-backs”? An add–back is an expense that is added back to the profits of the business (most often earnings before interest, taxes, depreciation, and amortization, or EBITDA), for the express purpose of improving the profit situation of the company. Transactions are typically based on EBITDA times a multiplier. Therefore, as a seller, you should be mindful to create the highest possible EBITDA number, but also be realistic in your approach.
I say be realistic, because in order for something to be added back it must have been subtracted or have impacted the P/L thru an expense category. You can’t get credit for an add-back if it never came out of the business. For example, distributions and dividends that typically run through the equity section of a company are not an add-back since they were never taken out.
The idea behind these add-backs is that these expenses are purported to be extraneous, one-time, and/or “owner’s” expenses. In plain English, these add-back expenses will either go away once the company is in the hands of the new owner, or won’t be incurred again.
Here are five common, legitimate, add-backs you should be aware of:
- Adjustments to Owner’s Compensation: Many owners of closely held companies, especially successful and highly profitable ones, give themselves oversized salaries and bonuses. Nothing is wrong with that, of course, but an acquirer is unlikely to pay that kind of compensation to the new president (and other execs). Therefore, the salary difference between the expected amount going forward, which should be based on reasonable compensation for such position at an arms length (i.e., no ownership), versus what was paid, is the add-back. For example, let’s say John Doe, GM for XYZ Company, overpaid paid himself with a salary of $500,000. If the baseline for such a position is $200,000, then $300,000 would be the add-back. Conversely, if that same GM was paid just $100,000 instead of the baseline $200,000, then XYZ would have a negative add-back of $100,000. Yes add-backs can be both negative and positive depending on the add-back.
- Taxes and Benefits: If you’re making add-backs for adjustments to an owner’s compensation, make sure to add back the corresponding taxes as well. If an owner and/or other employees are leaving the company post-acquisition, the benefits these people were paid may be appropriate add-backs, too.
- Severance and Lawsuit Settlements: Severance payments and lawsuit settlements may be cause for further due diligence on behalf of the Buyer, but these payments can be another example of a legitimate add-back—assuming these sorts of payments are truly rare and unusual for the company. They certainly should not recur in the future to be considered an add-back.
- Other Unique and Non-Recurring Business Expenses: These are handled individually. Some examples are discontinued operations, a failed initiative that did not produce desired results, bad hires, a one-time head hunter expense, peer group costs, and professional fees related to a future transaction (legal and accounting).
- Personal Expenses: Running personal expenses through the company is a common occurrence in closely held companies. Personal expenses may include the following:
- Any country club, or other club, dues and/or fees
- Owner’s car expenses (monthly payment, insurance, gas, and so on)
- Family members on the payroll that are non-working in the business
- Travel, meals, entertainment for personal use, not business purposes
- Any other expense that is personal in nature and not a business-related expense, such as home repairs or building repairs, etc.
So, what add-backs aren’t legit? This group is a little more difficult to quantify, because types of expenses are virtually limitless. Instead, you can apply a simple two-part rule of thumb:
Part 1: If one-time-only expenses show up on a company’s income statement year after year, they aren’t one time. They’re recurring, and therefore not a legitimate add-back expense.
Part 2: If the company will incur add-back expenses post-acquisition, they aren’t legitimate add-backs. Sellers shouldn’t try to add back expenses that will not go away post-closing.
And finally, knowing about add-backs doesn’t just benefit Sellers. Buyers should always pay close attention to a Seller’s add-backs. Don’t be afraid to challenge the Seller as to the legitimacy of the add-back.