Valuing a Business: The “Add-Backs”

Add-backs are items that have in the past been expensed by the business owners but that the new owners will not necessarily incur. Or, in cases such as depreciation and amortization, are non-cash expenditures that have been deducted for income tax purposes but are not actually instances where cash has left the business. There are dozens of potential add-backs and some of the more common ones are the seller’s compensation including all personal perks that are not required in the normal course of the business such as life and health insurance, retirement plan contributions, automotive expenses, lease payments for upscale cars, meals, etc. In addition, there are one-time expenses such as the purchase of a new software package to run a production line or the acquisition of a major piece of equipment. In past posts I’ve mentioned that when valuing a business, in most cases business broker starts by determining the business’ discretionary earnings. Well, an accurate calculation of discretionary earnings cannot be made without identifying the add-backs.

Seller or Owner Benefits

Add-backs are generally considered seller or owner benefits. Here’s a prime example. When we value businesses, we frequently see IRA or other retirement program contributions in the maximum amount permitted by the taxing authorities. If a spouse works in the business, such contributions can be doubled. We recently valued a wholesale/distribution business with revenue of just over $4 million. It was owned and managed by a husband and wife. The business contributed $20,000 to each of the spouses’ retirement plan in each of the most recent three years. This was a $40,000 add-back in each of those years as we determined what the discretionary earnings were.

Owners’ Salaries

Some people are of the opinion that the owners’ cash compensation should be added back. I disagree. The buyer of the business must be paid for his or her time – or hire management to run the business – and that means compensation commensurate with industry standards must be calculated as an expense. Now, “excess salary” is another story. If the industry standard suggests that hiring a manager that would allow the buyer to spend his or her days sailing of the coast of southern France would cost $150,000 and the seller was paying himself $250,000, there’s $100,000 of “excess salary” that would count as an add-back. Most businesses that we value have been paying the owners’ health insurance and in most cases the owners have put in place a pretty deluxe plan. The buyer may have health insurance through a spouse’ employer or may not want the same deluxe plan. The amount the seller has been paying for this item is another add-back.

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The Bottom Line

Valuing a business correctly is one of the key responsibilities of a professional business broker. Identifying the expenses that quality as add-backs is the only way to determine what the business’ discretionary earnings are – what its true earning capacity is. And without that number, it will be nearly impossible to establish value or determine a return on a buyer’s investment. If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast. I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week! Joe