A common issue that comes up when attempting to value a small business are the add-backs. The entire concept behind doing add-backs is to normalize a company’s earnings and to present the business as an owner operated entity.
For example, these can include non-recurring expenses (i.e. a one-time legal fee) because a new owner will not incur a similar expense as part of the ordinary operations of the business, or, it may include the salary of the owner’s spouse if they (the spouse) did not work in the business, but drew a salary nevertheless.
While these examples are clearly reasonable, buyers are often faced with questionable add-backs which only serve to distort the profits, and can become quite contentious deal points. This is especially the case when a business is for sale that is not experiencing any growth, and the seller wants to pretty up the numbers.
There are a few general rules to keep in mind when it comes to accepting, or rejecting add-backs:
The seller cannot attempt add-backs based upon his belief that the buyer could achieve expense reductions where they couldn’t. For example, a recent restaurant owner added back savings they felt a buyer could achieve on the Cost of Goods, claiming their food costs were too high. Let’s be realistic; if the seller of the business couldn’t lower food costs in the five years they owned the business, how could they expect they buyer to do so? Furthermore, even if the buyer can, that is for the benefit of the buyer, not the seller.
In addition to these, there are standard add-backs such as Owner’s Salary, Perks, Interest and Depreciation. But here too lies some potential hazards.
Sellers cannot add back their vehicle leases if the new owner will need a car to run the business. While the seller may have a Lexus, then sure one could “normalize” the expense with a Buick, but surely they cannot remove it altogether.
One big item where the sell-side is almost always guilty of padding the add-backs is regarding Depreciation. It is rarely a 100% add-back because there must be an offsetting allocation to replace the equipment being depreciated.
The exercise to accept of reject add-backs has to be done on an item by item basis. Sellers are free to pretty up the numbers however they want, but it is not a given that buyers should accept them. Just like all other aspects to the numbers, they have to be validated. If they are not reasonable, don’t include them, but your position has to hold water from an accounting perspective.
As businesses go through difficult times, sellers may make some pretty lofty claims, and do what they must to improve the financials. But as the old saying goes about putting lipstick on a pig, it’s still a pig.
Here’s a great article to learn more about add-backs and valuing a business, and especially the more common ones.
Have a great week.
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