Key Takeaways:

  • Add-backs adjust reported earnings by including non-recurring, discretionary, or temporary expenses to reflect the income a new owner could expect.
  • Common add-backs include EBITDA items (Expenses Before Interest, Taxes, Depreciation, and Amortization), along with owner's compensation, one-time purchases, and personal or non-recurring expenses.
  • Add-back depreciation allows businesses to offset asset depreciation to showcase actual cash flow impacts.
  • Depreciation is a non-cash expense that can reduce reported profits without affecting cash flow, thus often added back in valuation.
  • Legitimate add-backs should be carefully documented and justified as they can influence the valuation and financing options of the business. 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.

Documenting and Justifying Add-Backs

Proper documentation is crucial for any add-back claimed in a business valuation. Buyers and lenders often require proof that an add-back is genuinely non-recurring or discretionary. To strengthen a valuation, business owners should provide evidence such as financial records, receipts, and explanations for each expense. This process helps build trust with potential buyers by demonstrating transparency and accuracy in the valuation process.

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.

Impact of Depreciation on Cash Flow

Depreciation, as a non-cash expense, reduces taxable income but does not affect actual cash flow. This accounting method allows businesses to spread the cost of a large asset over time, reflecting a reduction in value but not necessarily impacting immediate financial health. Depreciation add-backs in business valuations help potential buyers see a clearer picture of a company's cash flow, as they reflect the business's ability to generate revenue without the deduction of non-cash expenses. The ability to add back depreciation enables a business to present a more favorable cash position to potential buyers​.

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.

Bonus Depreciation as an Add-Back

Bonus depreciation allows businesses to accelerate the depreciation of qualifying assets in the year they are acquired, providing an immediate tax benefit. This incentive can be especially advantageous for companies purchasing large equipment or property, allowing them to reduce taxable income substantially. However, in valuation, this accelerated depreciation is often added back to demonstrate what the company's earnings would be without this tax incentive, giving a more accurate representation of cash flow potential for future owners.

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.

Types of Non-Cash and Non-Essential Add-Backs

Several non-essential expenses can qualify as add-backs, especially those that do not directly contribute to the company’s core operations. Examples include personal expenses like travel, meals, and entertainment costs, which may be added back to indicate true earnings. Furthermore, expenses like company-sponsored events or personal car usage are generally classified as non-essential if they are unlikely to continue under new ownership. For valuation purposes, it is vital to separate operational from non-operational costs to give a prospective buyer a realistic expectation of ongoing expenses​.

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