Add-Backs: What Buyers Accept and What They Reject

An add-back is worth exactly as much as the documentation behind it. Every dollar a buyer accepts is multiplied in the purchase price, which is why owners want more of them and buyers scrutinize each one. The owners who do best are not those with the longest schedule of adjustments. They are those whose schedule survives a lender's review without a single item being struck.

What an add-back is

Reported net income on a tax return rarely reflects what a business earns for its owner. Small companies are run to minimize tax, and their books include expenses a new owner would not incur. An add-back restores one of those expenses to earnings so the buyer can see the true economic benefit.

The test is simple to state. An expense is a legitimate add-back if it is discretionary to the owner, unrelated to operating the business, or unlikely to recur. It must also be traceable to a specific entry in the books.

Adjustments almost every buyer accepts

Some adjustments are standard and rarely contested when supported.

• Owner's salary and payroll taxes, for one working owner, in an SDE calculation.
• Owner's health insurance and retirement contributions.
• Interest expense, since the buyer will have a different capital structure.
• Depreciation and amortization, as non-cash charges.
• One-time professional fees, such as legal costs for a settled dispute or the fees for the sale itself.
• Clearly personal expenses, where the invoice or statement shows the personal nature.

Adjustments that draw questions

A second group is legitimate in principle but depends on evidence and judgment.

Vehicles. If the owner's truck is used on job sites, a buyer will need one too. Only the portion that is personal, or the cost above what the business requires, is a real adjustment.

Family on payroll. A spouse paid $50,000 for a few hours of bookkeeping is a partial add-back. The buyer still has to pay someone to keep the books. The adjustment is the difference between what was paid and what the work costs at market.

Travel, meals and entertainment. Some of this spending maintains customer relationships. A buyer will accept the family vacation and reject the industry trade show.

Rent paid to the owner's real estate entity. If rent is above market, the excess is an add-back. If it is below market, the buyer will make a negative adjustment, which reduces earnings.

Non-recurring events. A flood repair or a one-time relocation qualifies. An item that appears under a different name every year does not. Buyers notice when a company has a non-recurring expense in each of the last three years.

Adjustments buyers reject

A third group tends to damage credibility as well as fail on the merits.

Unreported cash. An owner who claims unrecorded cash sales is asking a buyer to pay for income that cannot be verified and a lender to underwrite income that was not reported to the IRS. Neither will do it. The claim also raises a question about what else is unrecorded.

Normal operating costs described as one-time. Recurring repairs, routine marketing and ordinary bad debt are costs of doing business.

Deferred spending. If equipment maintenance was postponed to improve earnings, the buyer will find the worn equipment and adjust the price for it.

Projected savings. A statement that the buyer could cut two positions is an opinion about the future. It belongs in the conversation about opportunity. It is not an adjustment to historical earnings.

How lenders treat add-backs

The lender's view matters as much as the buyer's, because the lender determines how much debt the deal can carry. Banks generally accept fewer adjustments than buyers do, and they want each one tied to a tax return line or a general ledger entry.

SBA rules now require written justification for cash flow adjustments, including owner compensation. On acquisitions of $3 million or more, the lender must use normalized earnings from an independent quality of earnings report in its coverage calculation. An add-back that the report does not support is removed from the financing math regardless of what the buyer was willing to accept.

The negative adjustments owners forget

Normalization runs in both directions. A credible schedule includes the adjustments that reduce earnings.

• An owner who draws no salary but works full time requires a deduction for market compensation in an EBITDA analysis.
• A family member who works unpaid must be replaced at cost.
• Below-market rent on owner-held real estate will rise after the sale.
• One-time income, such as an insurance recovery or an unusually large project, should be removed.

Presenting these voluntarily builds trust. A buyer who discovers them independently will assume the rest of the schedule was prepared with the same optimism.

Building a schedule that holds

Four practices make the difference.

1. Tie every item to the books. List the account, the amount and the year, and keep the invoice or statement.
2. Cover three full years plus the current year. Consistency across periods is persuasive.
3. Stop running personal expenses through the company. An owner two years from a sale gains more from clean reported earnings than from the tax savings.
4. Separate the certain from the arguable. Present a base case of adjustments no one will contest, and discuss the others openly.

The purpose of the schedule is to let a buyer rely on the earnings figure. Aggressive adjustments work against that purpose. They may raise the asking price, but they tend to lower the closing price, because each item struck in diligence gives the buyer a reason to revisit the rest.

Twelve31 Advisors prepares and documents normalization schedules as part of every sell-side engagement and confidential valuation.