There’s an old expression, “you can put lipstick on a pig, but it’s still a pig”. That is exactly how I view many of the items sellers add-back to their financials to pretty up their businesses for sale.
The reality is that many add-backs are legitimate, but after twenty plus years in the business sale sector, an equal number are nothing more than lipstick. The issue of course is how can a buyer distinguish between the two?
Keep in mind; these
add-backs have a massive impact on valuations since a multiple is going to be attached to the final “Owner Benefit” figure to establish a purchase price.
If a three times multiple is used for example, a $50,000 add-back equals $150,000.
First, we need to establish what is “Owner’s Benefit” and why it is used. The concept is to reconstruct the financials to present a scenario of what a new owner can realistically expect to have available to pay themselves a salary, service any debt and grow the business assuming everything remains status quo after they purchase the business.
Note that Owner’s Benefit can also be referred to as Seller’s Discretionary Earnings, or Adjusted Cash Flow or Seller’s Cash Flow or a host of other terms. More important than the terminology is to be certain what is included and excluded in the compilation.
It is equally important to note that only items that were expensed can be added back. Also, add-backs of alleged personal seller items expensed through the business must be truly personal and not ones a new owner will incur. Also, look out for “one-time” expenses that sellers try to sneak in as add-backs. If these expenses occur on a fairly regular basis, then they are simply not one-time extraordinary expenses to be added back.
Regardless of the term used to describe Owner’s Benefit, the formula used to establish it is as follows:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation LESS Allowance for Capital Expenditures
Why Add Back Depreciation?
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life.
As an example: if the business buys a $25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct $5000 off its income to lessen its tax burden. However, as you can see, it is not an actual cash transaction. No money is physically leaving the business or changing hands. Therefore, this amount is added back.
Be Very Careful About Depreciation and Capital Expenditure Allowance
After completing any add-backs, it is critical that you take into consideration the future capital requirements of the business as well as debt-service expenses.
As such, in capital-intensive businesses where equipment needs replacing on a regular basis, you must deduct appropriate amounts from the Owner Benefit number in order to determine both the true value of the business as well as its ability to fund future expenditures. I am always astonished when I see sellers simply plunk down the entire Depreciation figure without any offset. What is more amazing however is the number of buyers who get suckered into believing it.
Why Add Back Interest?
Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Furthermore, in nearly all cases, the seller will pay off the business’ loans from their proceeds at selling; therefore, you will have use of these additional funds.
A Final Word
Establishing the correct Owner Benefit figure is one of the most critical aspects of the business buying process.
You need to be incredibly diligent and prepared to effectively analyze the financials. Further, you have to be knowledgeable to debate the numbers when necessary.
Since most prospective buyers will look at many businesses listed for sale, valuations, financials and add-backs are one aspect where every buyer must educate themselves first.
If not, I guarantee you will face a very expensive lesson later on.