Treating Add-Backs When You Value A Business

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:

• For an item to be considered “one-time” or non-recurring, it has to strictly adhere to that definition. A recent business listed for sale added back “excessive accounting fees” for three straight years. The seller claimed he “paid too much to his CPA” and a buyer could get the work done cheaper. However, the nature of the business involved invoicing clients, with a barrage of rebilling, extended terms, additional credits, sometimes offset by free inventory and services, and in all, it was an accounting mess. But, it was also part of the business and industry. As such, a new owner would face the same issues and offsetting accounting fees, so there is no way one could label this “one-time” expenses. After all, they happened every year.

• Since a business is listed as an owner operator, it is acceptable to add back a manager’s salary, but only if the owner is not active at all in the business, and the buyer will assume the manager’s role.

• Family member’s compensation can be a real issue. When an owner has their wife, brother-in-law or children in the business that will also leave after the sale, those job functions have to be replaced. Sellers will sometimes attempt to position so that the buyer can hire a new employee at a lower salary. While that may be the case, it isn’t always. And so, the buyer must validate what they can expect to pay for the position on the open-market, which may not be less, and sometimes can be more than what the seller was paying their family member.

• On the same subject, you may see family members who help out in the business and don’t get paid at all. Obviously, in this case, profits must be reduced accordingly.

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.

Comments

[Tom Vick]

Very insightful article re valuation, thank you.

I have a question regarding the validity of adjusting owner benefit with new owner compensation based on fair market value, prior to applying a multiple.

Your thoughts would be greatly appreciated!

FROM RICHARD: THE IDEA BEHIND ESTABLISHING AN OWNER BENEFIT IS TO DETERMINE THE AVAILABLE CASH A NEW BUYER WILL HAVE TO PAY THEMSELVES, SERVICE DEBT, AND GROW THE BUSINESS. AS SUCH, REDUCING THE OWNER SALARY TO FAIR MARKET PRIOR TO APPLYING A MULTIPLE DOESN'T MAKE SENSE. BUT, IF A BUYER WISHES TO DETERMINE THEIR POTENTIAL RETURN VERSUS OTHER INVESTMENT OPPORTUNITIES, AND THUS CALCULATES THE OWNER BENEFITS LESS THE COST OF A MANAGER FOR EXAMPLE, IT IS A GOOD EXERCISE BUT THAT IS ONLY TO MEASURE INVESTMENT VIABILITY, NOT A BUSINESS VALUATION.

[Sumar Jaffery]

I think even in owner operated businesses there should be a separation between return on capital and remuneration for the time spent managing the business. Presumably the owner/manager can earn the remuneration without investing anything. The difficulty of assessing how much of the Owner's cash flow should be attributed to their time and expertise and how much to the capital invested should not deter one from trying to determine the true return on capital.

FROM RICHARD: GREAT COMMENST - SEE MY NOTES TO TOM VICK'S POST.

[Neill Holmes]

"Since a business is listed as an owner operator"....It has always been my belief that the business be evelauated as a business. A job evaluated as a job. Mixing these adds to ambiguity when clarity is desired.\

FROM RICHARD: Thank you for your comments. You are correct that a business has to be evaluated as a business and not a job. However; I think you may have misinterpreted my comment: "Since a business is listed as an owner operator". It was not in any way contradictory to your belief. Rather, it was an explanation of how businesses are positioned for the valuation process. The foundation to small business valuations is presenting the financials in an owner-operated environment because it is the only viable basis upon which a buyer can determine a price using the historical seller’s discretionary income assuming the status quo of a business.

Yes indeed many buyers acquire businesses as a way to generate or replace an income stream and in doing so they far too often end up buying a job. However, the owner-operator basis on its own does not taint, nor impact the core intent of arriving at a meaningful basis. In fact, it does provide significant clarity, and especially in comparison to other valuation methods.

It is all of the other components to a business which can lead to a buyer properly assessing whether or not it is a sound entity and not simply a job.

[Leon Parker]

Another right on the money article. We are seeing some really way out suggestions by sellers these days.

In our seminars and when talking individually to customers I always tell them that they have to do their own version of a recast, because they have to figure out what they need, particularly for depreciation since that is almost always totally added back and frequently should not be, and there is probably a "real" vice accounting figure that should be "un-recast.

When real buyers get educated they start figuring out how to use the figures we give them, including the recasts, and coming up with their own analysis of what a business opportunity is worth to them, because the real value in most small businesses is a variable figure depending on the personality of the buyer.

FROM RICHARD: AS USUAL LEON - SPOT ON WITH YOUR ASSESSMENT AND ESPECIALLY THE RECOGNITION THAT BUYERS MUST TAKE THE RECASY AND COMPILE THEIR OWN ANALYSIS AND MAKING THE DETERMINATION OF THE BUSINESS' VALUE TO THEM. AS I OFTEN TELL BUYERS, "FORGET WHAT EVERYONE ELSE SAYS, WHAT IS IT WORTH TO YOU?"

[Wes Brown]

I have taken on a number of listings with earning from 25-50K with add backs. The tax returns are showing as little as 7K. Sometimes the owners claim that they took in a lot more in gross sales, but they were cash, so they did not report them. Of course they are never fundable by banks. Do you think it is an acceptable practice to add back cash sellers claim they collect, but did not report?

FROM RICHARD: Unreported income should never be an add0back. Should the seller wish to disclose this to a buyer is their choice, and that brings a whole set of new circumstances. Clearly, the onus is on the seller to prove any cash business, and if they can't (which is usually the case), a buyer certainly cannot be expected to pay a multiple for something that cannot be validated. For some, these businesses can be attractive. You may want to simply present it as a "cash business", but definitely do not add the alleged cash to the adjusted earnings.

[Metal Buildings]

Extraordinary article with ordinary points!The Add-backs are just superb. Everyone could read at least such wonderful articles.