So, you’ve decided to sell your business. After years of blood, sweat and tears doing whatever was 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.
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 (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.
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 know.
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 arm’s 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.
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 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.
These are handled individually. Some examples are discontinued operations, a failed initiative that did not produce desired results, bad hires, a one-time headhunter expense, peer group costs, and professional fees related to a future transaction (legal and accounting).
Running personal expenses through the company is a common occurrence in closely held companies. Personal expenses may include the following:
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.
Implement these five add-backs to improve the profit situation of your company and make it attractive to buyers.
Be prepared for the day when you may want — or need — to make a transaction.
Private equity buyers are very interested in our businesses and they’re paying impressive prices.
Understanding fair market value will enable you to establish a realistic sale price for your business.
Whether you’re selling a business, buying a business or merging two or more businesses, there are myriad tax and legal issues that need to be navigated, such as financing structure, purchase price allocation and fair trade laws.
