Identifying Add-Backs

What are add-backs? Why do they matter? And, how can they add value to my business? You will be able to answer these questions by the end of this video.

Watch time: 10 minutes

 

If you are a business owner exploring exit options, you are likely to come across the all-encompassing term “add-backs” while reviewing potential sales metrics. This broad term generally includes expenses that, while part of the operating costs, are not critical for generating core revenue or profitability, such as an owner’s personal expenditures. Or they could be inflated or excessive expenses. 

Regardless, before you can accurately determine the value or your business, you will need to identify and add these back. By reducing the company’s expenses this way, you will be able to present a more realistic picture of the value and profitability of your business to prospective buyers. As such, it is in your best interest to discover add-backs and adjust your ledger accordingly.

As you carefully comb through expense categories and identify items that should be added back, make sure that you have appropriate documentation to support your decisions. Buyers will want to review this information, along with anything else that may be uncovered during due diligence.

The following is a list of expenses that are typically added back.

Examples of Non-Business-Related Add-Backs

  1. Owner’s Compensation

As the business owner, are you taking a salary and bonuses that are above standard market compensation for the duties you perform? The difference between the amount of salary and bonus paid to the owner and the market rate paid to an unrelated party is an add-back to the owner’s compensation, reducing that expense. Payroll taxes associated with the change in salary should also be adjusted.

  1. Other Compensation

Often, business owners employ family members who receive compensation above the market rate for their positions. When determining add-backs, look for stipends paid to spouses or other family members who do not have specific job responsibilities.

  1. Auto Allowances

Does the company pay for your use of a company or personal vehicle? This category includes car payments to a finance company, fuel costs, maintenance work, and repairs. Consider whether it is customary to offer a car allowance for the type of business you own. Also identify any amounts paid for family members not employed by the company who are receiving this benefit.

  1. Travel Expenses

While travel may be an essential aspect of your company’s business development—and a certain level of travel is customary for most businesses—any expense run through the business that pertains to leisure travel is typically considered an add-back.

  1. Entertainment Expenses

Review all memberships to golf clubs or gyms, or other things such as season tickets to sporting events, and evaluate whether those are truly business related. While these expenses may have started as a good means to developing your business, ask yourself whether such things are still used for that purpose. If you are not bringing key vendors or clients to these events—if they are used primarily for personal enjoyment—the costs may be considered a personal expense.

  1. Boats, Planes, etc.

Look for other expenditures related to leisure activity (e.g., boats) or nonessential means of transportation (e.g., planes or helicopters) that are run through the business. Determine whether the items are necessary to maintain or increase the business’s current level of revenue. If they are not, but instead are considered nonessential to the operations of the business, they can be added back, improving profitability metrics.

  1. Insurance

The company’s expenses for insurance on any personal-use vehicles, boats, or planes (as determined in the categories above) should also be considered add-backs.

  1. Personal Use of Business Capabilities

You can add back any costs the company may have incurred in providing for you personally the same services that it regularly offers to customers.

  1. Miscellaneous Owner Perquisites

Perquisites that were expensed to the company but not listed in the above categories—anything from wine-of-the-month club memberships to household employees such as repairmen and housekeepers—should also be considered as add-backs.

Examples of Nonrecurring or Extraordinary Expense Add-Backs

  1. Customer Costs

One-time or exceptional discounts offered to particular customers could be considered add backs in order to normalize the earnings potential of the customer.

  1. Donations

You can add back any donations made by the company for charity or political purposes that were not considered crucial to the continued success of the business.

  1. Recruiting Costs

Identify expenses for any outside placement firm hired to recruit candidates for key positions if such expenditures are not part of the company’s typical recruiting costs.

  1. Fees Related to Selling Your Business

Identify any expenses incurred in the process of selling your company (e.g., investment bankers, attorneys, or accountants). Since these expenses are likely to occur in the future, keep them on the radar when preparing your financial statements going forward.

  1. Excessive Bad Debt Reserves

Provide support for the normal level of bad debt reserves recorded for your business. If you had a year in which these reserves were higher than usual, list extraordinary items and explain why they should be considered an add-back.

  1. Expensed Items That Should Be Capitalized

Identify items that for some reason were expensed rather than capitalized according to the usual procedures. Adding these back—i.e., applying your standard policy for capitalizing expenses—can provide a more accurate picture of the company’s profitability.

  1. Director Expenses

All compensation given to members of your board of directors, as well as all reimbursement for travel expenses, should be considered an add-back.

  1. One-Time Operating Expenses

Significant, one-time expenses incurred by your company during the past year that will not continue going forward are considered nonrecurring expenses and can be added back to normalize income.

  1. Obsolete Services, Equipment, or Software

Just like one-time operating expenses, the costs of shutting down one or more of your company’s services or lines of business could be added back. As with the other add-backs, this would provide potential buyers with a more accurate picture of its overall value.

  1. Elevated Legal or Professional Fees

Unusually high legal or professional fees in a given year—fees for extraordinary litigation or audit inquiries, for example—are nonrecurring and thus can be considered as add-backs.

  1. Accounting Method Timing Differences

Did your company change its accounting method in any year, causing certain expenses recorded in one period to be unmatched to the period in which the related revenues were recorded?  This mismatch can be quantified, and an adjustment can be made to normalize that period’s income.

An extensive array of add-backs is potentially available to a seller in determining the company’s baseline profitability. While an investor or potential acquirer may have a differing opinion of the adjustment amounts discovered during the due diligence process, having a supportable list of add-backs and amounts will establish a solid basis for negotiations in determining the normalized profitability of your business.  

For more information on selling your business, visit our Exit Planning Library.

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