SELLING A BUSINESS

Feb 15, 2023

What Is an Add-Back?

When a business is sold, the goal of a good business broker is to make a compelling argument for the business’s worth. Most owners are planning to fund their retirement with the sale of the small business they own, so every penny matters.

Where Do Add-Backs Come In?

As most businesses are valued based on their earnings, a good business broker will work with a business owner to identify “optional” expenses that can be added back to the earnings reported to the IRS. These “add-backs” are financial adjustments made to a company’s financial statements to reflect its true earnings.

As many owners will readily admit, the expenses reported to the IRS include a lot of “optional” expenses. Said another way, most owners will run personal expenses through the business. Owners should get credit for the true earning potential of the business, not just the earnings reported to the IRS after all of their personal or discretionary purchases.

What Are Examples of Common Add-Backs?

Add-backs can take many forms, but some common examples include:

• Non-recurring expenses: These are expenses that are unlikely to occur again in the future, such as legal fees associated with a one-time lawsuit or a loss from a discontinued product line.

• Owner compensation: If the owner of a business takes a salary or other compensation that is higher than market rates, an add-back can be made to adjust for this. This is especially common when a spouse or family member draws a market salary from the business but only works part-time (or not at all!).

• Personal expenses: Sometimes, business owners will use company funds to pay for personal expenses. These expenses can be added back to reflect the true profitability of the company. At Beacon, we’ve seen it all: from the standard country club membership to exotic sports cars!

• Depreciation and amortization: These are non-cash expenses that are included in the company's financial statements but don't actually affect its cash flow. To arrive at a more accurate representation of the company's profitability, an add-back can be made to remove these expenses from the calculation.

Here are the most common add-backs that we see:

1. Owner’s Salary and Bonuses

2. Compensation of Non-Working Family Members

3. Personal Vehicle Purchases and Leases

4. Owner’s Insurance (e.g., Life Insurance, Health Insurance)

5. Owner’s Retirement Benefits and Plans

6. Charitable Contributions

Add-Backs Must Be Legitimate and Justifiable

Add-backs can have a significant impact on the valuation of a business. By adjusting for non-recurring or non-operating expenses, the true profitability of the company can be more accurately reflected, which can lead to a higher valuation. These adjustments can more than double the earnings of the business. The resulting earnings is considered “Seller’s Discretionary Earnings”, which we’ve discussed in our guide to small business valuations.

It's important to note that add-backs must be legitimate and justifiable. Inaccurate or fraudulent add-backs can be illegal and can result in legal consequences for both the buyer and seller. Moreover, if a buyer is planning to use a bank loan from an SBA lender, the bank will need to verify that reported add-backs are indeed legitimate.

In conclusion, add-backs are a common part of business sales that are used to adjust financial statements for non-recurring or non-operating expenses. By doing so, a more accurate picture of the company's profitability can be obtained, which can boost the valuation of the business.

At Beacon, we work with owners to determine the highest price that we can justify when bringing a business to market.

John McCleary

Transaction Advisor

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.