When selling a business, one of the most critical aspects of valuation is determining its true profitability. However, financial statements don’t always reflect the full earning potential of a business. That’s where add backs come into play. Understanding what add backs are and why they are important when selling a business is critical to valuing a business.
Understanding what add backs are and how they impact business valuation can mean the difference between an undervalued sale and maximizing your return. In this blog post, we’ll explain what add backs are, why they matter, and how they influence the sale price of a business.
What Are Add Backs?
Add backs are expenses or discretionary costs that are adjusted in a company’s financials to reflect the true profitability of the business. These expenses may be legitimate business costs but are either non-recurring, owner-related, or not necessary for business operations.
When valuing a business, add backs help normalize earnings, giving potential buyers a clearer picture of the business’s actual earning potential. This is particularly important for small to mid-sized businesses where owners may have personal or one-time expenses included in the financial statements.
Why Are Add Backs Important?
1. More Accurate Business Valuation
When determining a business’s value, buyers and brokers typically look at Seller’s Discretionary Earnings (SDE) or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Add backs help ensure these earnings reflect the true profitability of the business.
Without add backs, the reported net income might seem lower than the actual earnings. By adjusting for these expenses, sellers can justify a higher valuation and asking price.
2. Maximizing the Sale Price
A business’s sale price is often based on a multiple of its earnings (e.g., 3x SDE or 5x EBITDA). If add backs increase the reported earnings, even slightly, it can significantly impact the final sale price.
For example, if a business’s net income is $200,000, but legitimate add backs total $50,000, the adjusted SDE is $250,000. If the business is valued at a 3x multiple, that’s an extra $150,000 in sale price—just from properly accounting for add backs.
3. Transparency for Buyers
Buyers want to know exactly what they’re getting when purchasing a business. Clearly identifying and justifying add backs builds trust and prevents misunderstandings during negotiations. If buyers feel confident that the numbers accurately represent the business’s earning potential, they are more likely to move forward with the purchase.
Common Types of Add Backs When Selling a Business
Not all expenses qualify as add backs. However, certain categories are widely accepted when preparing a business for sale.
1. Owner’s Salary and Perks
- Many small business owners pay themselves a salary that may not reflect what a new owner would earn.
- Personal expenses run through the business (e.g., car payments, travel, health insurance, or meals) can often be added back.
- Family members on the payroll who are not actively working in the business may also be considered an add back.
2. Non-Recurring Expenses
- One-time legal fees, consulting fees, or other professional services that won’t be ongoing.
- Large repairs or equipment purchases that are not part of normal operating costs.
- Unusual marketing expenses, such as a major rebranding campaign.
3. Discretionary Expenses
- Charitable donations made by the business.
- Sponsorships that benefit the owner personally rather than the business.
- Memberships, club dues, or entertainment expenses that are not essential to operations.
4. Depreciation and Amortization
- Since depreciation and amortization are non-cash expenses, they are often added back when calculating EBITDA.
- These expenses don’t directly impact cash flow, making them a common add back.
5. Interest and Taxes
- Business valuation typically focuses on earnings before interest and taxes, so these expenses are added back to get a clearer picture of operational profitability.
- These costs vary based on financing and tax strategies, making them irrelevant to a new owner’s expected earnings.
How Add Backs Affect Business Valuation
Business valuation is often based on a multiple of adjusted earnings. Properly identifying add backs ensures that the earnings multiple is applied to the true profit potential of the business, rather than an understated net income.
For example, let’s say a business reports a net income of $100,000, but with $50,000 in legitimate add backs, the adjusted earnings become $150,000. If the industry standard valuation multiple is 2x, the difference in sale price would be:
- Without add backs: $100,000 × 2 = $200,000
- With add backs: $150,000 × 2 = $300,000
This example demonstrates how add backs can significantly impact the perceived and actual value of a business.
Best Practices for Identifying and Presenting Add Backs
1. Work with a Business Broker or Advisor
A professional business broker or accountant can help identify valid add backs and ensure they are presented correctly in financial statements. Their expertise can prevent overestimating or missing key adjustments.
2. Keep Detailed Records
Buyers will likely scrutinize add backs during due diligence. Maintain proper documentation, such as receipts and explanations for one-time or discretionary expenses, to justify adjustments.
3. Be Transparent with Buyers
Clearly explain each add back and why it is being adjusted. If buyers feel that add backs are misleading or exaggerated, it could lead to lost trust and a failed deal.
4. Know What Buyers Expect
Certain add backs, such as personal expenses and non-recurring costs, are widely accepted. However, some adjustments—such as speculative future savings—may not be accepted by all buyers.
Conclusion
Add backs play a crucial role in selling a business by providing a more accurate picture of its true profitability. By identifying and properly presenting add backs, business owners can justify a higher valuation, maximize their sale price, and ensure transparency with buyers. This is the reason why it is so important for understanding what add backs are and why they are important when selling a business.
If you’re preparing to sell your business, working with an experienced business broker can help you navigate the valuation process and ensure you’re getting the best possible return on your investment. Understanding and leveraging add backs is one of the most effective ways to position your business for a successful and profitable sale.
