If you’ve started looking beyond the surface to purchase a company, it’s HIGHLY likely that you’ve encountered the often mysterious and controversial “add-back” in the seller’s financial statements. So what is an add back and why is it in there?
Here’s the best definition I’ve found for an add-back in this context: “Income statement expense items that are added back to the business net pretax operating profit, in order to arrive at an accurate estimate of the business profitability.” Okay…that definition is a bit academic, so I’ll try to break it down into simpler terms as it relates to business acquisitions.
The best way to describe add-backs in this context is: business expenses on the financial statements that will essentially “go away” when the business is sold and handed over to the buyer. So, it is an attempt by the seller to essentially show what the actual profitability and subsequent value of the company is when you take out expenses that are either not “real” company expenses, or are related to the current owner and will not be transferring to the buyer, or were one-time expenses that the new owner would not incur. Let me provide some examples of each that would likely be legitimate add-backs.
Let’s start with expenses that are not “real” company expenses:
- A family member on the payroll who doesn’t really do any work
- In this scenario the owner could be paying his wife or a child to help spread out the tax burden of his profitability, but that person doesn’t actually do any essential function for the company. So, the buyer would not be bringing on that expense when they take over.
- Note: Always beware of these “add-backs” to make sure that in fact this person really doesn’t work there. If this person is someone that really does do some work, and you will have to incur cost to replace them, it may not be a fully legitimate add-back and would be a point of negotiation with the seller
- Excessive owner salary
- This happens a lot. The owner is currently paying himself $300,000 per year, which is well more than the position would cost the buyer if he or she had to hire someone to perform that same function.
- Note: It is very common today for the seller to try to add-back 100% of the owner salary to make their adjusted numbers look even better. I personally disagree with this, because there is some cost of replacing the owner’s work, even if the new owner is going to be doing that job…. in other words, the new owner isn’t going to be expected to work for free. I will write an entire article about just this part of the topic in the future because it varies deal to deal and is often a heated topic in negotiation. Meanwhile, feel free to contact me via our free business buying support forum if you need advice on this topic on a specific deal.
- Personal expenses being run through the company
- This is extremely common when looking at small business opportunities. The owner simply buys things for his or her personal use and runs them through the company as an expense, which makes it an “expense” that you as the new owner would not incur.
- Note: This can make the due diligence process much more difficult if there are a lot of these items because you can’t just take the seller’s word for it. You or your CPA will have to look at each of those expenses to verify that they truly are not company related expenses.
Next, let’s cover some examples of add-back expenses that’s related to the current owner and will not be transferring to the buyer:
- Loan interest
- If the company has a loan that you are not taking on as the buyer (meaning the seller is responsible for that loan, and it is not transferring over to the buyer), this interest would be a legitimate add-back.
- Often, the owner of a small business will have a life insurance policy on himself that is paid for through the business, sometimes referred to as a “key-man policy”. He or she may also have a very high end and/or expensive health insurance plan for his or herself. These types of expenses obviously would not transfer over to the buyer.
Lastly, let’s take a look at a few examples of legitimate “one-time expense” add-backs:
- Legal fees
- You may see a large legal fee expense during one year of financials that doesn’t exist in other years. This could be a law suit that they had to deal with, or could also be legal expenses related to the document preparation required to get the company ready to sell. Those are not expenses that would transfer over to the buyer.
- Note: You would still want to evaluate these expenses in due diligence to make sure that the requirement of legal expenses isn’t something inherently related to the business that you would likely incur in the first few years. There are some businesses that simply require more recurring legal work, so they would need to be factored into future financials and the overall valuation.
- Facilities upgrade
- This could be something as simple as the business purchased a new building and spent several thousand dollars renovating it to fit their operation. If you are inheriting that building and it is already set up properly for you, it’s not an expense that you would incur as the buyer, so I would consider it a legitimate one-time expense add-back.
- Note: If this is related to equipment upgrades or growth that you anticipate will continue, it may be an expense that you will incur in the future and should be put into the expenses and valuation accordingly. This can be something up for debate in negotiation, so if you need help with this, feel free to reach out to us on the Free Business Buying Support Group.
The others you will see pretty much every time and are standard in valuations involve taxes and depreciation. These are a lot more simple; taxes (talking about income related taxes, not sales and/or property taxes) are tied to the income of the business anyway, so would not be something that should be considered an expense that results in lowering the value of the business.
Depreciation is a “non-cash” expense as well, and given that cash flow is the most popular variable in valuing a business, you can see why most sellers would want to add depreciation back in to their numbers.
To help bring this full circle for you, I’m going to show some actual adjusted financial statements below and point out the various add-backs; why they are there, what they mean, and what we look for to determine their legitimacy.
This is a fairly simple one and was provided to me from a broker/seller. Take a quick look at it, and I will have some comments down below.
|DETAILED FINANCIAL ANALYSIS PROVIDED BY SELLER|
|DATA SOURCE||Tax Returns||Tax Returns||Tax Returns|
|COST OF GOODS SOLD|
|PRE-TAX NET PROFIT||84,797||99,622||101,569|
|ADJUSTMENTS / ADD BACKS|
On this statement, you will see their reported tax earnings, and what they are calling “discretionary earnings”, which is the reported earnings, plus add-backs.
As I’ve said earlier, interest and depreciation are standard, but the next 2: owner’s distributions and owner salary, take some evaluation. What they are basically saying is that those 2 expenses are not going to transfer over to the new owner, so they shouldn’t be included in the real financials that are being used to value the business. Fair enough, but here is how we approached it.
First, we needed to understand what the “owner’s distributions” are, because in the accounting world a true “distribution” would not be in the expenses to begin with…it would be part of equity. In this case, I’ve learned that these are really personal, and non-company expenses that the owner ran through the business. This is something that is going to have to be looked into in this case, especially given the high dollar amount relative to the overall numbers on this deal.
The 2nd one is a point of a lot of negotiation on almost every deal we look at…owner’s salary. In this case, they have tried to add back the entire amount that the owner pays himself in a salary…basically saying that this is not an expense that a new owner will incur. I tend to disagree with this in cases where the owner is also an essential part of the organization and its management. In my opinion, a business has to have a manager, and that manager is going to come at a cost no matter who owns it.
The extent that you negotiate this particular add-back as it relates to the total valuation of the company depends on your personal situation. A few of those factors are:
- How bad you want this business
- What does the ROI look like even with that add-back
- Do you already own a similar business so you really won’t incur new management costs
- Is the seller offering good seller financing terms
There’s no exact formula because everyone has different things they are looking for in a business. However, I tend to negotiate that to some extent, while still looking at the total picture and ensuring that if I were to pay 100% cash for the business, I would be able to get at least a 25% ROI.
Here is another example with more extensive add-backs. Take a look, and again I’ll have several comments down below.
|Auto Expenses: Personal Autos||$||22,715|
|Bank Charges: Higher while managing business from NY||$||10,000|
|Fuel: Personal Autos||$||5,641|
|Legal: Charges for related company paid by mistake||$||18,964|
|License & Tax: Liability payment misclassified as expense||$||9,321|
|Telephone Exp: Excess over $350/mo is personal||$||367|
|Travel: All Personal||$||7,437|
|NY State Tax – Affiliated company tax paid by Turmar|
|Auto Expenses: Personal Autos||$||22,715||1%|
|Bank Charges: Higher while managing business from NY||$||10,000||0%|
|Fuel: Personal Autos||$||5,641||0%|
|Legal: Charges for related company paid by mistake||$||18,964||1%|
|License & Tax: Liability payment misclassified as expense||$||9,321||0%|
|Telephone Exp: Excess over $350/mo is personal||$||367||0%|
|Travel: All Personal||$||7,437||0%|
|NY State Tax – Affiliated company tax paid by Turmar|
Because there are so many different add-backs on this one, I’m going to break them each down here for you.
- Family wages: We discussed this as an expense that we see often. Similar to the previous example, the main thing you need to look for and determine is whether or not these family members actually perform a job function for the company that the next owner will have to replace (at a cost). The seller/broker agreed with our take on the situation and we agreed to adjust the add-backs and valuation accordingly.
- Auto Expenses: Again, a common add-back, but what we needed to look for was whether or not these auto expenses were actually for vehicles unrelated to the business. In this instance that turned out to be the case (it was for a family member’s BMW who didn’t even work at the company), so we agreed with this add-back in full.
- Bank Charges: This is an example of one that was related to the current owner and would not transfer to the new owner. They were managing a lot of the businesses from New York even though they weren’t located anywhere near New York. Bank fees, including credit card processing fees, were higher in New York at that time, which is why they noted it as an add-back. This would again take verification, which we did and it turned out to be legitimate.
- Fuel (personal autos): This was the fuel related to the auto expenses above for a vehicle and person completely disconnected from the business. Legitimate add-back.
- Interest Expense: This was on a loan they had on the business, which the buyer would not be taking off…meaning it is being paid off with proceeds at closing. This was an easy one to verify that it was a legitimate add-back.
- Legal: Normally, legal fee add-backs are related to a one-time legal situation such as a law suit or specific business deal. In this case, however, it was simply a mistake wherein they’ve paid a legal bill out of this company that was actually due from one of their other unrelated companies, and didn’t catch it until after their tax returns had been filed. This was verified by our team and determined to be legitimate.
- License and tax: Normally, business licenses are a recurring expense and would not be added back, so this one caught our attention. Again, this simply turned out to be an accounting mistake in how they coded it, and was actually a payment on a loan that would not be transferred to the buyer. Legitimate add-back.
- Telephone Expense: Given that this was only $367, we really didn’t worry about it as it didn’t have much of an impact on the value either way.
- Travel: This is one that often comes up under the category personal expenses that are run through the company. But just because it’s common, doesn’t always mean it is 100% legitimate as an add-back. One thing we see at times is that the travel is actually related to a trade show or conference, but some personal travel is added to it…meaning they attend a trade show but extend the stay into a personal vacation and expense the whole thing. When that is the case, you need to consider the fact that if trade shows were necessary for the seller, they will be necessary for you. I recommend determining how much of the cost would be incurred for the trade show alone, and adjusting the add-back to eliminate the excess. If that happens, you’ll find that the majority of the travel cost is a real expense (you still have to fly, stay at a hotel, eat…etc) so this add-back will be significantly reduced.
As I’ve said earlier, add-backs can be controversial at times. We sometimes walk away from deals early on at the site of too many add-backs, simply because the time and cost to verify them all just wouldn’t be worth it. Another factor to consider is if there are too many “questionable” add-backs. It may make the acquisition more difficult to get financed, especially with SBA. This would be largely dependent on the banker, his or her understanding of how small businesses often run, and of course the bank’s tolerance for risk.
I’m not saying that you should be scared and run away from any business with a lot of add-backs. The other side of that coin is that it opens the door to negotiation on price and ESPECIALLY terms, that may not be otherwise available.
If you need any help with that or have any questions at all, please feel free to contact us with any questions, and if you haven’t already, please join our FREE business buying support forum here at: https://www.facebook.com/groups/buyabusiness.
I hope this helped you get a better understanding of add-backs. See you in the forum!
Institute for Business Acquisitions