When you’re selling your business, potential buyers want to know how much profit the business is really making.
Add-backs can help present a clearer picture of the business’s financial health and are crucial when selling a business because they can significantly impact the perceived value of the business.
What are add-backs?
Add backs are essentially expenses that a business owner has incurred but aren’t directly related to the operation of the business.
They’re added back into the business earnings to give a more accurate picture of its profitability, and potentially a higher valuation.
Why are add-backs important?
By eliminating expenses that are not related to the core operations of the business, potential buyers can better understand the company’s true earning potential.
This can make the business more appealing and potentially lead to a higher selling price.
However, not all add backs are created equal. There are valid ones and then there are those that are, well, not so valid.
Valid add-backs
Valid add-backs are expenses that provide a genuine representation of the company’s earning capacity. Here are some examples of valid add-backs:
- Owner’s Personal Expenses: If the owner has run personal expenses through the business, these can be added back. For example, if the owner bought a personal vehicle and recorded it as a business expense, this would be a valid add-back.
- Owner’s compensation: If the current owner pays themselves a salary beyond the market rate, the excess amount can be added back.
- One-Time Legal Fees: If the business has incurred legal fees for a one-time event, such as a lawsuit or the negotiation of a contract, these can be added back. They are not considered regular operating expenses.
Invalid add-backs
On the other hand, invalid add-backs are expenses that are part of the normal course of business and tied to business operations. Here are some examples of invalid add-backs:
- Regular Employee Salaries: If the owner tries to add-back the salary of an employee who is crucial to the business operations, like the owner’s partner who does all the accounting, this would be invalid. The new owner would still need to pay for that function.
- Marketing Expenses: If the business has an expense related to marketing or advertising that brings in customers, this cannot be added back. It’s a necessary cost for generating revenue.
- Cost of Goods Sold: The cost of materials and labor directly tied to the production of goods sold by the company cannot be added back. These are essential costs for the business to operate and generate revenue.
- Failed Business Initiatives: If a business has invested in a new project or initiative that didn’t pan out, the losses from this cannot be added back. These are considered part of the risks of doing business.
- Routine Maintenance and Repairs: The costs associated with the regular upkeep of business equipment or property are not valid add-backs. These are considered normal operating expenses.
- Ongoing legal fees or bad debt: These are also considered a part of doing business and cannot be added back. If we did, we’d be inflating the business’s earnings.
Conclusion
Understanding add backs is a crucial part of business valuation and helps potential owners see the real profitability of a business.
It’s not just about the numbers though, but also about knowing what’s behind them.
And remember, not all add backs are valid, so they may be scrutinized when you’re selling your business!
