Add-Backs for Seller’s Discretionary Earnings
Most savvy business owners will expense as much as possible and minimize their net income to save on taxes. This strategy is advantageous until it comes time to get the business valued for a possible sale. Suddenly the lowered net income makes the business financials less appealing to an investor or business buyer.
To account for this disparity, add-backs are used. Add-backs are elements used in financial accounting to recast profit to better represent the earnings a new owner can expect.
As the name suggests, they are expenses added back to a company's bottom-line profits when determining Seller's Discretionary Earnings (SDE) or EBITDA (earnings before interest, taxes, depreciation).
What Are Add-Backs in SDE?
In the case of Seller’s Discretionary Earnings, add-backs are expenses that don't directly contribute to the business's financial performance, or are optional expenditures that a new buyer might not choose to make. By classifying certain expenses as add-backs, a seller can show a potential buyer only costs that will continue under the new ownership.
By eliminating discretionary expenses, buyers get a more accurate picture of the profits a business will generate the new owner. While there are generally agreed-upon parameters for the types of expenses considered add-backs, it's common for buyers to disagree with the add-backs a seller uses, or for lenders to dispute add-backs.
Business owners want to use as many add-backs as possible to increase the company's value; buyers worry that some add-backs can unrealistically overvalue the company, and lenders want to eliminate as much risk as possible.
While there are no hard-and-fast rules, a good rule of thumb to determine whether an expense can be used as a legitimate add-back is to ask whether a buyer will have to continue paying the expense after they acquire the business.
Examples of Add Backs Typically Included in Seller's Discretionary Earnings
Add-backs fall into these five categories: discretionary personal expenses, discretionary operating expenses, non-operating expenses, non-recurring expenses, and depreciation and amortization. Keep in mind, though, the accounting for add-backs can be complicated, and while not governed by typical GAAP accounting rules, there are some commonly accepted practices.
For example, if a business has more than one owner, only one of the salaries can be added back. Furthermore, for any owner-operators who will need to be replaced, a market-rate salary should be deducted from SDE to reflect the cost of hiring managers with comparable skills to run the business.
Discretionary Personal Expenses
Discretionary personal expenses are typically included in an SDE calculation as add-backs. These are personal expenses that only benefit the current owner of the business and would not be incurred if the business is managed by a new buyer. These might include:
- The owner's salary (including income taxes paid on the wage)
- Perks such as health insurance and fitness club dues
- Automobile leasing expenses
Discretionary Operating Expenses
These are legitimate business expenses that are discretionary in nature and may vary significantly based on management style. Examples include:
- Client entertainment (like tickets to sporting events)
- Business travel
- Professional association dues
- Optional training programs
- Marketing expenses above industry norms
These expenses may be disputed as add-backs if an argument can be made that they are necessary to maintain business relationships and revenue.
Non-operating expenses
Non-operating expenses are costs unrelated to core business operations. These might include:
- Interest expenses
- Losses from investments
- Foreign exchange costs
- One-time legal settlements
- Costs from discontinued operations
This organization more accurately reflects the nature of each type of expense and their treatment in SDE calculations.
Non-recurring expenses
Non-recurring expenses can often be excluded, but not if they occur regularly. For example, if a business owner paid an IT service provider to perform maintenance on its computer system every quarter, that expense wouldn't qualify as add-backs. But if the computer system crashed due to a power outage, the cost of repairing it would be considered an add-back because the crash was a one-time occurrence and unlikely to be a recurring expense to the new buyer.
Depreciation and amortization
Companies that take income tax deductions for depreciation on equipment and property can usually add back the expense when preparing an SDE. The same goes for businesses that amortize investments, such as the cost of developing intellectual property.
How Add-Backs Affect Business Value
Many factors go into setting a sale price for a business, but the starting point is usually the market benchmark determined by applying an industry multiple to the company's revenue or cashflow.
Because the add-backs used are multiplied, they have a leveraged effect on the business valuation. Here's an example of how it works:
Jim, the owner of a sports apparel wholesale business, shows a net profit of $600,000 on his latest tax return.
The deductions Jim adds back to the net profit are:
- Owner's salary plus income taxes: $80,000
- Charitable donations to several sports organizations: $500
- Qualified retirement plan contributions: $5,000
- Client dinners: $2,000
- Interest paid on a line of credit: $500
Adding back the above expenses, $88,000, brings the business’s SDE to $688,000. If the SDE multiple for a sports apparel wholesale business were 2.9, the valuation for Jim's company would be $ 1,995,200. If Jim then added back an additional $5,000 for business trips that are not recurring, and his automobile lease payments of $2,400, the benchmark value increases by over $21,000 to $2,003.610.
How Add-Backs Can Affect Financing
Add-backs are not only important in valuation, but they may meaningfully impact the way a buyer is able to finance a business purchase. The higher the SDE, the more financing options are available to a business buyer. Lenders are more likely to approve a loan if the SDE shows ample cash flow to meet the repayment terms.
Including appropriate add-backs in SDE calculations can help buyers qualify for larger loans with more attractive interest rates. That means better sale terms for both the business owner and buyer.
As with all financial matters, an experienced CPA or business broker should be involved to ensure that financial statements are prepared properly, and legal and tax issues are considered.