By Vishal Bharucha, president of VNB Business Brokers, a leading Business Brokerage and M&A Advisory firm.
As an M&A professional, one of the challenges I often experience is evaluating add-backs and adjustments (also known as normalizations). Too few could result in a business being undervalued and too many can result in an inaccurate business valuation.
There are several ways a business is valued and one of these ways is a method that incorporates “adding back” expenses from the profit and loss statement into the business’ net earnings, providing the buyer with an accurate and holistic view of the business’ performance for a single working owner. While the net earnings are relevant for accounting and taxation purposes for the IRS, it doesn’t illustrate the full picture of the business for a prospective buyer.
As such, what professional business brokers aim to do is present an accurate view of how the business is performing — the distribution hereof is a separate subject matter. To this end, there are specific categories of expenses that are reverted into the net earnings, which result in the “earnings before interest, tax, depreciation and amortization,” or EBITDA — which is what buyers are really interested in when assessing a business.
There’s a bit of science when applying add-backs to the profits of a company, and when it is executed correctly it results in the adjusted EBITDA, which is defined by Investopedia as “a measure computed for a business that takes its earnings and adds back interest expenses, taxes, and depreciation charges, plus other adjustments as part of a metric.”
Types Of Add-Backs
Add-backs are envisaged to disappear upon the current owner’s exit, are not likely to occur again and generally fall into seven categories: abstract accounting expenses, interest expenses, seller’s personal expenses, excessive expenses, remuneration to seller, non-recurrent expenses and income reversal.
It is important to understand these add-backs categories so as to be able to accurately identify EBITDA increases and ultimately the accurate value of the business. Add-backs are also key for a buyer to understand the full scope of financial benefit the current owner experiences.
1. Abstract Accounting Expenses: These expenses generally include depreciation and amortization. These are abstract expenses that appear on the business’ profit and loss statement, and while they are considered legitimate deductions for accounting purposes, they haven’t truly occurred (i.e., there is no actual movement of cash) and subsequently don’t affect the financial benefits derived by the business owner.
2. Interest Expenses: Applying for loans is completely at the discretion of a business owner, and in addition, any interest that occurred due to late payments is also an expense that is reverted back into the net earnings. The theory is that it is also the business owner who is required to secure operating capital, take out loans and settle these interest charges.
3. Seller’s Personal Expenses: Most business owners add expenses back into the net earnings that are personal in nature and for the benefit of the seller or their family members to the business’ expenses. Some of these expenses include mobile phone charges, motor vehicle expenses, subscriptions, donations, personal accounting charges, etc. — this list not being exhaustive. When the business owner exits the business, these expenses are envisaged to disappear and these funds revert to the bottom line for the benefit of the new owner.
4. Excessive Expenses: From time to time, business owners are presented with excessive expenses that are added back to the net earnings at the sole discretion of the current business owner. The incoming buyer is not subjected to continue paying these expenses upon acquisition of the business to operate it at its current level.
5. Remuneration To Seller: Remuneration to the seller is an add-back reverted back into the net earnings that can arise as an issue for some buyers. Generally, these expenses are payments including wages, director’s fees, or superannuation to the business owner or a spouse. It is regarded as the primary benefit derived by an owner of the business.
The principle of this concept is that the business generates the revenue and the business owner is merely disseminating it to themself through remuneration, instead of dividends. However, it should be noted, that an adjustment will be required based on the difference between the market-based amount for owner compensation and the actual owner compensation. This will enable the prospective buyer with accurate insight as to the value of compensation he or she could derive from the business.
6. Non-Recurrent Expenses: These are expenses that will not be incurred by the business upon the exit of the current business owner.
7. Income Reversal: Income reversal refers to income that is removed from the net earnings to provide an accurate illustration of the business’ financial position. Income reversals are deductions to the total add-backs, and this comprises business income that isn’t attributable to the full benefits derived by the owner and includes interest received, insurance recoveries or the profit on the sale of assets amongst others. These sources of income do not form part of the core income generation model of the business. While it may seem counterintuitive, it positions the seller favorably in the eyes of a buyer who will be in a better position to properly assess the business.
When selling a business, it is vital that the financials of the business are presented as accurately as possible to prospective buyers. Consult a professional business broker to assist you in identifying the best way to include add-backs so as to enable you to increase the EBITDA and provide a potential buyer with an idea of the business’ future cash flow.