Add-backs for business valuation are expenses that are added to a business's profits to improve the company's apparent profits. Usually, they are added to the business earnings before interest, taxes, amortization, and depreciation are subtracted.

When selling a company, add-backs are expenses that are considered unusual, non-recurring, or discretionary, but you want to make sure the buyer knows about them. The expenses can be considered to be temporary, and a new company owner should not have them.

What Add-Backs Are Legitimate?

Since there are many different types of add-backs, buyers and sellers do not necessarily agree on which are legitimate. To evaluate them, the key is their intended purpose — to adjust the company's taxable income so that it reflects the true income that a new owner can expect in the future. When they are evaluated by a lender, the rules are typically more strict.

There are three main reasons that a company would need to use add-backs to determine its true earnings:

  • To borrow money for business use.
  • To reinvest in the business.
  • To determine a fair salary for the buyer when they begin running the business.

Standard Add-Backs

The standard add-backs are known as EBITDA, which stands for Expenses Before Interest, Taxes, Depreciation, and Amortization.

Depreciation means deducting a specified amount of money every year from the value of an asset, spreading its loss of value over its useful lifetime. This amount is used to reduce the taxes the business pays each year. However, since money does not actually change hands in this process, depreciation is added back.

Interest is added back because when a business is sold, the seller usually pays off any loans it has outstanding with the sales proceeds. Therefore, the new owner will have no interest expense.

Additional Add-Backs

In addition to the typical EBTDA add-backs, there are other items that are added back. One of these is owner's compensation, because the new owner can decide for themselves how much money to take as a salary.

Similarly, a business owner may pay family members either more or less than the going rate for the type of work they do. If they are paid more, and the new owner can replace them with a lower-paid employee or contractor, the difference between the two amounts would be an add-back. On the other hand, if the family member is paid less than they would cost to replace, the company's earnings would need to be adjusted in the other direction.

One-time expenses such as equipment or vehicles can be considered add-backs since the new owner would not need to purchase them again. Retirement plan contributions can also be considered an add-back if the new owners will not be making the same contributions going forward.

Other types of expenses that may be counted as add-backs include the following:

  • Employee severance payments.
  • Lawsuit settlements.
  • Personal expenses — any type of expenses that are not related to running the business.
  • Losses due to unexpected events, such as storm damage or fire.

Non-Recurring and Discretionary Expenses

One of the more complex areas regarding add backs is personal expenses. These are considered discretionary, meaning that the owner can decide how much to spend on them. The owner's salary is a discretionary expense. The owner might also enjoy several perks such as use of a company car, a cell phone, life insurance, or company sponsorship of a family member's team or event.

The seller may have had significant expenses that are business-related but are still unlikely to be incurred by new owners. Travel expenses may fall into this category, since the new owners may not feel the need to make the same type of trips. Expenses that the seller may have deemed necessary to the business operation may seem frivolous to the new owner.

Determining whether or not an expense is a legitimate add-back can be complicated, so it's a good idea to consult with an accountant or attorney to find out how to treat them properly. As a general rule, if the expenses recur annually, they would not be considered a limited one-time expense and would not qualify as add-backs. If the new owner will have the same expenses, they are not add-backs.

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