Seller Add Backs: Legit?

A common question I’ve heard while discussing the value of small businesses relates to earnings “add backs”. An add back is an expense (or income item) that has been recorded on the financial statements but does not accurately represent the true economic value in the performance of the business. Add backs are usually prepared by owners and their brokers when marketing a business for sale and also when attempting to attract capital.

One of the benefits of being the owner of a privately held small business is that owners can take tax deductions that wage and salary earners are unable to claim. This potential benefit is part of the risk and reward scenario that comes from owning and operating a small business.

When it comes to valuing or selling the business, these tax deductions can be inconvenient in that they can artificially understate the true cash flow of the operating business. Cash flow impacts the business valuation and therefore also impacts how much the buyer is willing to pay or a bank willing lend. To navigate this situation, it’s important to understand how to deal with these legitimate tax deductions or as they are called, add backs. The concept behind doing add-backs is to normalize a company’s earnings and to best represent the true cash flow and benefits that accrue to a small business. 

For example, add backs can include non-recurring expenses (e.g. a one-time legal fee or natural disaster expense) 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 he or she did not work in the business, but drew a salary nevertheless. 

While these examples are clearly reasonable, buyers and valuation analysts are often faced with questionable add-backs which distort the profits, and can become contentious deal points. This is especially the case when a business is only marginally profitable with limited to no growth, and the owner/seller wants to pretty-up the numbers. 

The theory behind add backs is that these expenses are represented to be one-time non-recurring expenses and/or owner’s discretionary expenses. In other words, add back expenses won’t need to be incurred in the hands of the new owner or won’t be incurred again. 

Some legitimate add backs include the following: 

·        Owner/officer compensation: Many owners of closely held companies, especially successful and highly profitable ones, give themselves large salaries and bonuses. Nothing is wrong with that, of course, but an acquirer may not need to pay that kind of compensation to the new officer(s). There are several good officer compensation benchmarking resources that can be used to help estimate a market level of officer compensation including RMA, individual state offices of labor, Economic Research Institute, and several others. A common way to address this issue in a reasonable manner is to answer the question; how much would a passive owner need to pay a person to replace the officer’s duties? In cases of acquisitions, it may also be appropriate to consider the lifestyle requirements of the new owner/officer. 

·       Discretionary or non-operating expenses: Running discretionary personal expenses (discretionary to the buyer) through the company is a common occurrence in closely held companies. These personal expenses can be legitimate add backs because it would not be necessary for a new owner to continue to incur these expenses. However, it is important to view personal expenses in combination with owner’s compensation to ensure that the total combined adjustment is reasonable. Common personal expenses may include: 

     ·        Owner’s car expenses (monthly payment, insurance, gas, and so on) 

     ·        Family members on the payroll

     ·        Travel, meals, entertainment for personal use, not business purposes

     ·        The clubs (hunting, country, health, and so on)

     ·        Any other expense that is personal in nature and not a business-related expense for the buyer

·        Benefits and taxes: If making add backs for adjustments to owner’s compensation, the corresponding benefits and taxes may be material and can be added back as well. If an owner and/or other employees are leaving the company after the acquisition, the benefits these people were paid may be appropriate add backs, too. However, it is important to be careful with some normal operating expenses like health insurance or life insurance that are routinely required in most businesses.

·        Severance and lawsuit settlements: Severance payments and lawsuit settlements can be another example of a legitimate add back as long as the expenses are truly non-recurring in nature. If it is expected that a lawsuit or severance may occur every few years as a normal part of business, one option is to smooth a year of abnormally high historical expense across a number of years to “normalize” the expense. Regardless, extraordinary lawsuits may be cause for further due diligence on behalf of buyer and/or valuation analyst.

·        Depreciation and Amortization: Depreciation and amortization are expenses that allow a business to deduct a certain amount of money each year from an asset so that its original cost is reduced over time, usually its estimated useful life. However, the expense is not an actual cash transaction. No money is physically leaving the business or changing hands due solely to depreciation. Therefore, it is common to see depreciation fully added back each year in an adjusted income statement. However, a “before depreciation” earnings figure most likely doesn’t represent the true operating cash flow of a business because most businesses require some sort of ongoing investment in fixed assets (also often referred to as economic depreciation, normalized capital expenditures, or reserve for replacement). As such, it is often useful to estimate an ongoing economic depreciation figure to account for the ongoing investment in fixed assets required by a business.

·        Interest Expense: Most sales of businesses (and lending for acquisitions) are made based on the total value of the enterprise before debt financing. Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Further, in nearly all cases, the seller will pay off the business’s loans from their proceeds at selling. As such, the amount of historical interest expense incurred by the business is often irrelevant to a new owner. Interest expense is therefore usually added back to estimate the operating earnings produce by the total operating enterprise before financing.

So, what add backs aren’t legit? 

The illegitimate add backs may be more difficult to quantify because there is no limit to the nature of the potential expenses. Instead, apply a simple two-part rule of thumb:

·        If one-time-only expenses show up on a company’s income statement year after year, they aren’t one-time nonrecurring; they’re recurring and therefore not a legitimate add back expense.

·        If the company will incur add back expenses post transaction or valuation date, they aren’t legitimate add backs.

It is also important to note that a seller/owner cannot attempt add-backs based upon his or her belief that the buyer could achieve expense reductions where the seller couldn’t. For example, a restaurant owner may add back savings she felt a buyer could achieve on the Cost of Goods, claiming their food costs were too high. However, to be realistic; if the seller of the business couldn’t lower food costs in the years she owned the business, how could she expect they buyer to do so? That said, there may be some specific instances where the most probable outcome is a reduction in expense in a certain category and there is adequate documentation to prove the reduction. However, those cases are usually in the minority.

Another situation to be aware of involves cash versus accrual accounting financial statements. It is very common for small businesses to utilize cash based accounting on their financial statements and CPA prepared tax returns. When this is the case, it is important to carefully scrutinize any add backs that involve the timing of cash payments. For example, I recently analyzed an asphalt sealcoat business located in the Midwest that utilized only cash based accounting. The sealcoat business in the Midwest is very seasonal with most of the work being completed before Winter. In this case, the selling broker made a large adjustment for cash receipts received in January 2012 for work performed before the end of the year 2011. However, in that case, the broker did not consider that the 2011 full year unadjusted earnings also included the prior year January 2011 cash receipts from work performed in 2010. As such, the January 2012 add back was not appropriate without considering the prior year seasonal timing as well.

In summary, buyers, lenders and valuation analysts need to pay close attention to seller’s add backs and shouldn’t hesitate to challenge and inquire as to the legitimacy of the add back. For sellers and owners, be careful not to add back any expenses that won’t go away after the transaction or valuation date.