Addbacks: Adjusting Earnings for Valuation or a Business Sale

As I mentioned in my post on business valuation, the value

of a business is usually -almost always - dependent on earnings.  But it is an adjusted earnings, called

Discretionary Earnings for small to mid-sized companies and EBITDA for larger

companies.  Discretionary Earnings, for

example, is adjusted to make sure it is before taxes, interest and

depreciation.  In addition, “owner’s

benefit” is also added back, and that is usually the most contentious

“addback”.

Owner’s benefit, by definition, is the benefit for ONE

owner.  This means you add back the

salary, benefits, and perks of one owner. 

Often we’ll see multiple owners (such as a husband / wife team) and in

this case only one of the salaries is added back.  In fact, sometimes we see a spouse (yep,

usually the wife), working full time in the company and not getting paid at

all.  In that case we have to do a

“negative addback” to account for the fact that a new buyer is unlikely to find

someone to work for free!   By the way, if you are buying a company watch

out for this – some brokers will not adjust for a spouse’s free work and you

can overpay for a small company by a significant amount simply for the fact

that there is a salary missing from the expenses.

Other addbacks for owner’s benefit are health insurance,

life insurance, pension and then any owner perks, such as personal expenses

written off as company expenses. The purpose is to try to determine what a new

owner would enjoy by owning the company. 

Sometimes it gets awkward when the owner is taking so many

“perks” that it really amounts to tax fraud. 

Everyone does some tweaking, for example putting the families’ cell

phones into the company, writing off car expenses when the company doesn’t

really use a car, etc.   These are

accepted as legitimate addbacks, interestingly even by the SBA, which is after

all a part of the government.   You can

usually addback a few tougher items, like a son or daughter that is on the

payroll but isn’t actually working.  But

at some point you have to draw the line (or the bank will draw one for you).

Other addbacks are one-time items such as moving expenses or

major repairs.  I had one owner, having

read about how to do addbacks, that tried to convince me that tools, books and

just about everything he bought was a one time expense.  That would only be the case if a new owner

never had to buy anything again.  So as a

rule, only significant one-time expenses are used.

Once you have the correct addbacks added back into earnings,

you then have your Discretionary Earnings, and (theoretically), it can be used

to compare the company to similar companies, or even across industries for the

purposes of valuation or showing a new buyer what he/she can make from the business.