Scrutinize add-backs before selling your company

March 15, 2018|Tyler Carlson

Understand how adjusting financial statements can impact your business sale.

Every owner seems to think financial adjustments, or “add-backs,” are a good thing when selling a business…well this isn’t always the case, so let’s take a closer look at how to identify credible, supportable add-backs to show the “true” profitability of the company.

A typical financial statement prepared by an investment banker will focus on deriving earnings before interest, tax, depreciation and amortization (EBITDA). EBITDA is one way to communicate business performance and show profitability by eliminating the influences of the capital structure.

In general, the owner of a privately held business has discretion over the capital structure and the expenses that impact profitability. Therefore, these discretionary expenses decrease profitability and reduce the company’s tax liability, providing a financial benefit to the owner.

To prepare a company’s financial statements and illustrate the performance on a “normalized” basis, it is standard practice to adjust reported financial statements for owner-related, nonoperating or nonrecurring items. Nonrecurring items are often described as “unusual,” “extraordinary” or “one-time.” These adjustments involve the add back or elimination of certain expenses, to create a more accurate view of the company’s performance with a new owner. Positive EBITDA adjustments would decrease operating expenses or cost of goods sold, thus increasing EBITDA, and the reverse is true with negative EBITDA adjustments.

Learn about the most common add-backs we see in businesses

Owner’s discretionary expenses

Most privately held businesses have expenses related to the owner that can be deemed discretionary and that would not likely continue under new ownership. These owner “perks” are added back to increase EBITDA. Some examples include: personal entertainment tickets, country club dues, excessive personal or family automotive expenses, personal travel and entertainment, family perks (e.g., 401(k) contributions, cell phones), donations and life insurance.

Owner’s compensation

In some situations, owners pay themselves a higher salary compared to what it would cost to hire a replacement. In this case, an adjustment would be made to add back the net effect of the compensation gap.

For example, if the owner’s salary is $500,000 but a replacement’s fair market salary is $200,000, then $300,000 would be added back to operating expenses, thus increasing EBITDA. However, a negative adjustment of owner’s compensation is made if the owner is making below market compensation.

Unusual, extraordinary or one-time expenses

A company may have unusual, extraordinary or one-time expenses that can be reasonably added back if it is unlikely to occur again. Some examples include: unusual legal fees, plant closing, position eliminations, unusual one-time inventory write-offs to reduce taxes, nonrecurring recruiting fees, or losses incurred for launching a new product. As a general rule, add-backs in this category should be legitimately defended as truly extraordinary items and the proper data should support these add-backs.

Fair market value of rent expense

Many privately held businesses have set up a situation where the operating business is in one legal entity and the real estate is in another entity for tax reasons. In this case, the business has discretion over the rent expense paid to the real estate entity, which may or may not be at fair market. If the operating company is paying the real estate entity above fair market rent, then there’s a positive EBITDA adjustment.

For example, if the operating business is paying $1 million to the real estate entity, but fair market rent is $750,000, then $250,000 would be added back. If the operating business is underpaying rent then a negative EBITDA adjustment would be made.

Keep these points in mind regarding add-backs

When presenting add-backs, consider the view a buyer will take with the proposed add-backs. Generally speaking, a buyer will increase its scrutiny of the company’s financial statements when a high dollar amount and number of add-backs are included. Therefore, it’s imperative to have supportable data for each add-back.

If you lack the data (e.g., invoices, receipts) to tie the proposed add-back to the financial statements, it’s generally not advisable to include. However, reasonable and logical assumptions can be made to estimate certain add-backs, if data isn’t available or is too time-consuming to obtain. But be careful not to have too many of these or you will start to lose credibility with the buyer.

As best practice, the owner and investment banker should exercise discretion as to whether a given charge is nonrecurring, unusual, extraordinary or part of normal business operations. This determination is sometimes relatively subjective, further complicated by the fact that certain expenses or events may be considered nonrecurring for one company, but customary for another.

Nonetheless, as the investment banker, it’s our job to help verify owner suggested add-backs, identify other legitimate add-backs and accurately present the financial statements to buyers. Thus, working with an experienced investment banker is vital to accurately identifying true add-backs, which will maximize your net proceeds and get you the best terms possible.

For more information or to explore your options related to normalizing financial statements, please contact Tyler Carlson, vice president, at tc@taureaugroup.com or any member of the Taureau Group team at 414-465-5555.