Key Takeaways

  • Add backs are financial adjustments made to reflect the true profitability of a business, often used during valuation or when preparing for a sale.
  • Common add backs include owner compensation, personal expenses, non-recurring costs, and discretionary spending.
  • Buyers and valuation experts scrutinize add backs to determine a business’s normalized earnings or seller’s discretionary earnings (SDE).
  • Add backs must be clearly documented and justifiable to be accepted during negotiations or due diligence.
  • Categories of add backs include discretionary, non-recurring, accounting, and one-time adjustments.
  • Strategic use of add backs can increase perceived business value, but unjustified add backs can erode buyer trust.

Cash flow add backs are completed to account for adjustments that were made in calculating the net income of the business based on the accrual method of accounting. Net income is determined by adding or subtracting differences in expenses, revenue, and credit transactions. These adjustments are performed to account for the non-cash items that were included in the net income of the business. The reason that there is a difference between cash and income is because the accrual basis of accounting treats sales as profit and expenses as losses, even though the revenues from the sale may not have actually been collected and expenses may not have yet been paid.

What Are Add Backs?

Cash flow add backs relate to expenses that will not be included in the prospective buyer's future income statement. The expenses will be added back to the profits of the organization for the purpose of improving the financial appearance of the business. Applying and understanding add backs and adjustments helps in managing an organization's earnings on a quarterly basis. After completing the add backs and adjustments, a true illustration of the amount of cash flow that the organization is generating should be revealed. In other words, you'll be able to see the true value of the business.

Add backs may massively influence the valuation of the company because a multiple is going to be attached to the final owner benefit's number to calculate a recommended purchase price. For example, if a four times multiple is adopted, a $100,000 add back will equal a $400,000 increase in valuation. "Owner's benefit" may also be known as:

Remember the following points when working with add backs:

  • When calculating the owner's benefit, only expenses may be added back
  • When including personal seller expenses as add backs, verify that they're truly personal and not expenses the new owner will need to pay
  • Watch out for one-time expenses that a seller may attempt to sneak into the calculation as an add back

The formula used to calculate the owner's benefit is: Owner's Salary + Pre-Tax Profit + Additional Owner Perks + Depreciation LESS Allowance for Capital Expenditures + Interest

One of the most critical aspects of purchasing a business is calculating the correct owner's benefit. Individuals looking to calculate the number themselves must be prepared to be extremely diligent. Also, the purchaser should be extremely aware as to how the owner's benefit was created should they need to openly debate the figures.

When Are Add Backs Used?

Add backs are commonly used in several financial and strategic contexts, including:

  • Business valuation: Add backs help normalize earnings to reflect the true economic benefit of ownership, especially when calculating EBITDA or SDE.
  • Selling a business: Sellers use add backs to enhance the company’s profitability profile and justify a higher asking price.
  • Loan applications and financing: Lenders may consider adjusted cash flow when assessing creditworthiness or structuring deals.
  • Internal financial analysis: Owners and managers may use add backs for internal decision-making, budgeting, or forecasting purposes.

Add backs are especially relevant for small- to mid-sized businesses where personal and business expenses are often intermingled.

Purpose of Add Backs When Selling a Business

A substantial number of add backs will increase the company's profits on an adjusted or normalized basis. The value of the business will be increased when a multiple is utilized. Remember that the intention for using add backs isn't to increase the value of the business. Instead, it's intended to display the correct historical cash flow statement to a prospective buyer.

Buyer Considerations and Risks of Add Backs

While add backs can make a business appear more profitable, buyers approach them with caution. Risks and considerations include:

  • Inflated earnings: Overstating add backs can mislead buyers and lead to valuation disputes or deal retractions.
  • Verification challenges: Buyers may request financial records or explanations to verify that proposed add backs are legitimate and recurring.
  • Trust erosion: Excessive or dubious add backs (e.g., undocumented travel expenses, family payroll) may cause buyers to question the integrity of the financials.
  • Deal structure impact: Add backs influence earn-outs, holdbacks, and deal multiples, making accuracy essential for fair terms.

Buyers often consult financial advisors to assess the credibility of add backs and ensure the adjusted cash flow aligns with industry norms.

What Are the Different Kinds of Add Backs and Adjustments

The financial transactions of the business will need to be analyzed in order to identify potential add backs and adjustments. Positive add backs will include:

  • Owner compensation: The difference between the current compensation rate and the market rate
  • Personal and benefits expenses: Includes benefits that will not be granted going forward
  • Market value adjustments: The difference between a normalized expense and one that is under or over market value
  • Inventory adjustments: May include adjustments between FIFO and LIFO
  • Taxes and benefits: If including add backs for any adjustments to owner's compensation, it's important to add back the interrelated taxes
  • Lawsuit and severance settlements: As long as these expenses are unusual or rare, they may be added back
  • Personal expenses: The owner's personal expenses may also be added back

While add backs are an ongoing historical expense, positive adjustments are one-time occurrence. Positive adjustments are expenses that were incurred once, in a prior year but will never happen again and may include:

Remember if a one-time expense hits the organization's income statement across numerous years, than it's not a one-time expense. Instead, it's a recurring expense and not eligible to be included as an add back expense.

Add Backs vs. Adjusted EBITDA and SDE

Add backs serve different valuation purposes depending on the financial metric used:

  • Adjusted EBITDA: Used in larger businesses, this metric adds back interest, taxes, depreciation, amortization, and discretionary/non-recurring expenses. It reflects core operational profitability.
  • Seller’s Discretionary Earnings (SDE): Often used in small business valuations, this metric includes all add backs plus owner compensation. SDE helps buyers understand the total financial benefit available to a new owner-operator.

Choosing between adjusted EBITDA and SDE depends on the business size, industry, and buyer expectations.

How to Justify and Document Add Backs

For add backs to be credible and accepted by buyers or lenders, thorough documentation is essential:

  • Maintain records: Invoices, receipts, and payroll reports can help support claimed add backs.
  • Provide context: Explain why an expense is non-recurring or discretionary, such as a legal settlement or owner’s personal trip.
  • Use consistency: Apply add back criteria consistently across periods and accounts to avoid the appearance of manipulation.
  • Seek third-party validation: An accountant or business broker can help identify and validate proper add backs.

Transparent, well-documented add backs build confidence with prospective buyers and can support higher valuations.

Common Examples of Add Backs

Here are typical examples of add backs often used in recasting financials:

  1. Owner’s salary and perks: Excessive salaries, bonuses, or benefits beyond market norms.
  2. Family member wages: Payments to family members not involved in the business or paid above market rate.
  3. Personal expenses: Auto leases, meals, travel, club memberships, or insurance policies used for personal benefit.
  4. One-time or non-recurring expenses: Lawsuit settlements, moving expenses, or COVID-related costs.
  5. Non-cash expenses: Depreciation and amortization are added back when calculating EBITDA.
  6. Professional fees: One-time consulting, legal, or accounting fees unrelated to ongoing operations.
  7. Inventory write-downs or bad debt adjustments: Often considered when they don’t reflect future expected operations.

These add backs help provide a clearer picture of sustainable earnings, which is essential when estimating a business’s true value.

Frequently Asked Questions

  1. What is the purpose of add backs in business valuation?
    Add backs adjust reported income to reflect the true earning potential of a business, helping buyers and sellers agree on a fair valuation.
  2. Are all add backs accepted by buyers?
    No. Buyers often scrutinize add backs, and only clearly documented, reasonable adjustments are typically accepted.
  3. Can depreciation be included as an add back?
    Yes. Depreciation is a non-cash expense commonly added back when calculating EBITDA.
  4. What’s the difference between add backs and adjustments?
    "Add backs" typically refer to expenses removed to increase profit, while "adjustments" may also account for underreported revenues or other normalizing changes.
  5. Who determines which add backs are valid?
    Ultimately, it's a negotiation between the buyer and seller, often with input from financial advisors, brokers, or CPAs.

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