At Unbroker, we know that understanding business valuation add-backs is crucial for accurately determining a company’s true worth.
These financial adjustments can significantly impact the final valuation, making them a key factor in negotiations and decision-making processes.
In this post, we’ll guide you through the process of identifying and applying add-backs correctly, helping you maximize your business’s value.
What Are Business Valuation Add-Backs?
Defining Add-Backs
Add-backs for business valuation are expenses that are added to a business’s profits to improve the company’s apparent profits. These adjustments add specific expenses back to a company’s earnings, providing a more accurate picture of its financial performance. Add-backs typically include costs that won’t continue under new ownership or aren’t essential to the business’s core operations. For instance, if a business owner charges personal car expenses to the company, these costs would be added back to the earnings (as they wouldn’t be incurred by a new owner).
The Impact on Business Value
Add-backs play a vital role in determining true business value. They can substantially increase a company’s perceived profitability and, consequently, its valuation.
Common Types of Add-Backs
Several types of add-backs frequently appear in business valuations:
It’s important to note that not all expenses qualify as add-backs. Recurring costs necessary for the business’s operation (such as rent or essential employee salaries) should not be included.
The Importance of Accurate Documentation
Thorough documentation is essential when applying add-backs. Each add-back should have clear justification and support from financial records. This transparency increases the credibility of your valuation and smooths the due diligence process for potential buyers.
As we move forward, we’ll explore how to identify potential add-backs in your business. This next section will help you uncover hidden value and present a more accurate picture of your company’s financial health.
Uncovering Hidden Value in Your Business
Owner’s Compensation and Benefits
EBITDA add-backs are adjustments intended to normalize earnings and provide a clear picture of a business’s operating performance. These adjustments typically include examining your compensation package. If you pay yourself above-market rates, the excess can be added back to your business’s earnings. For example, if the industry standard for your role is $100,000, but you draw $150,000, that extra $50,000 could be considered an add-back.
Benefits also merit attention. Health insurance, retirement contributions, and company cars often fall into this category. The costs associated with a company vehicle used for personal purposes can be added back.
Non-Recurring Expenses
A thorough review of your financial statements will reveal one-time expenses. These might include:
- Legal fees for a specific lawsuit or contract negotiation
- Costs related to moving your business location
- Expenses for a major equipment upgrade or system overhaul
- Consulting fees for a special project
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 expenses when calculating your business’s value.
Personal Expenses Charged to the Business
Many business owners, particularly in smaller companies, charge personal expenses to their business. This practice can lower tax liability but also artificially deflates the business’s profitability. Common examples include:
- Personal travel disguised as business trips
- Home office expenses that exceed reasonable limits
- Family members on payroll who don’t contribute substantially to the business
- Club memberships or subscriptions used primarily for personal enjoyment
A detailed review is essential. Even small personal expenses can accumulate to a significant amount over a year.
Depreciation and Amortization
Adjusted EBITDA is a metric of a business’s earnings that starts with net income and adds back interest, taxes, depreciation, and amortization expenses. These legitimate accounting expenses don’t represent actual cash outflows. As such, they’re typically added back to a business’s earnings. A review of your income statement and balance sheet will help identify these non-cash expenses.
Consider a $50,000 piece of equipment depreciated over five years. You’d record a $10,000 expense each year, but this $10,000 doesn’t represent an ongoing cash cost and can be added back.
The key to successful add-backs lies in thorough documentation and clear justification. Each add-back should have support from financial records and an explanation that demonstrates its legitimacy to potential buyers.
The meticulous identification of these potential add-backs doesn’t artificially inflate your business’s value, but rather reveals its true earning potential. This process can significantly impact your final valuation, potentially increasing your sale price by thousands (or even millions) of dollars.
As we move forward, we’ll explore the correct application of these add-backs to ensure you maximize your investment without overstepping ethical boundaries.
How to Apply Add-Backs Correctly
Gather Comprehensive Financial Records
Start with all relevant financial documents. Include tax returns, profit and loss statements, balance sheets, and general ledgers for the past three to five years. Comprehensive financial records lead to more accurate add-back calculations.
The National Association of Certified Valuators and Analysts supports the users of business valuation and financial litigation services.
Conduct a Thorough Expense Analysis
Examine your expenses line by line. Identify items that fit the add-back criteria discussed earlier. This process takes time but pays off. Recent surveys found 66% of business brokers think “an increasing number” of buyers will enter the market in 2024.
Focus on these areas:
- Owner’s compensation and benefits
- One-time or extraordinary expenses
- Personal expenses charged to the business
- Non-cash expenses (depreciation and amortization)
Document and Justify Each Add-Back
Create clear documentation for each identified add-back. Explain why it qualifies. This transparency builds trust with potential buyers and smooths the due diligence process.
Avoid Common Pitfalls
Watch out for these common mistakes when calculating add-backs:
A word of caution: maximize add-backs accurately and honestly. Overreaching can backfire, potentially scaring off buyers or leading to disputes during due diligence. A study found that there was a sharp spike in the worldwide deal failure rate following the collapse of Lehman Brothers. Nineteen percent of deals failed during this period.
These guidelines position you to apply add-backs correctly, presenting a clear and accurate picture of your business’s true value to potential buyers. This approach increases your chances of a successful sale and helps you achieve the best possible price for your business.
To calculate Seller’s Discretionary Earnings (SDE), start with your business’s pre-tax income. Then, add back the owner’s salary, personal expenses, and any one-time or non-recurring costs. This method provides a more accurate representation of the business’s earning potential for potential buyers.
Final Thoughts
Business valuation add-backs reveal a company’s true financial health and potential. These adjustments uncover hidden value and present a compelling picture to potential buyers. Proper application of add-backs can significantly impact the final sale price of a business (by revealing actual earning potential free from one-time expenses or owner-specific costs).
Sellers must maintain integrity throughout the process to avoid eroding trust or derailing a sale. Transparency and accuracy are essential for a successful transaction. Overreaching or misrepresenting add-backs can have severe consequences for the sale process.
Unbroker offers valuable support for those navigating the complex world of business sales. Their expertise can benefit sellers when dealing with intricate financial aspects like add-backs. Unbroker helps sellers maximize their business value while ensuring a smooth, efficient sale process.
