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Selling

How lenders view your add-backs

When you sell a business, the price is usually a multiple of what the business earns. So the number everyone argues about is earnings, and most of that argument is about add-backs.

An add-back is an expense on your books that the next owner won't have. You add it back to reported profit to show what the business really earns. Done honestly, add-backs are normal and expected. Done loosely, they're the first place a buyer's lender starts cutting.

Two ways to measure earnings

Smaller businesses are usually priced on seller's discretionary earnings, or SDE. That's profit before your own salary and benefits, plus interest, depreciation, and legitimate add-backs. It answers the question an owner-operator buyer cares about: how much will this business pay the person running it?

Larger businesses are usually priced on EBITDA, which is earnings before interest, taxes, depreciation, and amortization. With EBITDA, your salary isn't added back. Instead, it's replaced with what it would cost to hire a manager to do your job at a market wage. If you've been paying yourself far less than that, EBITDA goes down.

Add-backs that usually hold up

Truly one-time costs, with paperwork. A lawsuit settlement, storm damage the insurance didn't cover, a one-time consulting project. If you have the invoice and it hasn't happened before, buyers usually accept it.

Personal expenses you can document. A family phone plan or a vehicle used mostly for personal driving, if you can show it clearly. Running personal costs through the business may raise tax questions of its own, so talk with your CPA about them, and plan to stop well before a sale.

Above-market rent to yourself. If you own the building and charge the business more than market rent, the difference is an add-back. It works the other way, too. If you charge below market, a buyer will subtract the difference.

Add-backs that usually get thrown out

One-time costs that happen every year. If there's a big repair or a "special" expense in each of the last three years, a buyer will treat it as a normal cost of doing business.

Family on the payroll. If your spouse or kids are paid but don't work in the business, that pay is an add-back. If they do real work, someone will have to be hired to replace them, and a buyer will count that cost.

Savings that haven't happened. "We could cut a truck and save money" describes a plan. Buyers pay for what the business has already earned.

Cash that wasn't reported. Some owners say the business makes more than the books show. Lenders and buyers won't give any credit for income that isn't on the tax return, and it can create real problems for the seller. If this applies to you, talk to your CPA and an attorney before you talk to any buyer.

How lenders check

A buyer's lender starts from your tax returns. Every add-back has to connect back to a line on those returns and be backed by an invoice, a bank statement, or a payroll record. On larger deals, the buyer will often hire an accounting firm to do a quality of earnings review, which tests every adjustment line by line.

The more your add-backs add up to compared with reported profit, the harder a buyer and lender will push. A long list of small, vague adjustments does more damage than a few large, well-documented ones, because it makes the buyer doubt everything else.

What to do before you sell

Build an add-back schedule now: each adjustment, the amount by year, the reason, and the document that supports it. Look at it the way a skeptical lender would and cut anything you can't defend. Then clean up the books going forward, so that by the time you sell, there's less to explain.

We do this review as part of every valuation, and it's often the fastest way to find out what a buyer will really pay.