Owner add-backs and why they matter in business valuations

EBITDA-business-valuations

Posted On June 24, 2021 by Brentwood-growth

One of the great benefits of owning a business is the ability to leverage the expenses that the business is allowed to pay in order to minimize tax liability annually. This is completely legal and prudent. The only time this is an issue is when it comes time to value your business in preparation to sell it. That is because the formula for business valuations is:

               EBITDA x Multiple = Valuation

We will talk a lot about the multiples business trade for, but today let’s focus on EBITDA and more importantly, adjusted EBITDA.

The first adjustment is that interest, taxes and depreciation need to be added back to net income. This is because companies should be compared on a debt-free basis (therefore no interest expense). For taxes, businesses and individuals are either flow throughs or in different tax brackets, and there are different accounting methods used for depreciation.

The second adjustment that needs to be made are owner add-backs. This can be the opposite of what you have been doing from a tax perspective. For taxes, you are running as many expenses through the business as possible to reduce tax liability, and now we want to add those back to show as great a profit as possible.

Additionally, we want a clean starting point for a potential buyer to make their own assumptions on what management structure they want to put in place to run the business, and the cost of that.

reoccurring and non-reoccurring-addbacks

 

Add-backs fall into two categories: reoccurring and non-reoccurring.

Reoccurring add-backs:

  • Owners’ total compensation
  • Compensation of other family members in business
  • Medical insurance for owners or family members
  • Owner and family members’ car expenses (monthly payment, insurance, gas, etc.)
  • Travel, meals, and entertainment not 100% business related
  • Clubs (country or golf, health, hunting/fishing, etc.)
  • Phone expenses (personal and family members)

Non-reoccurring items add-backs:

  • Revenue items
    1. PPP loans
    2. Sale of asset
  • Expense items
    1. Loss on insurance claim non-reimbursed
    2. Major repair, improvement, or purchase
    3. Major legal, accounting or consulting expense
    4. Any other major expense that is reoccurring

To better understand the impact of add backs in business valuations for selling a business, please see the example below.

Here you’ll see that $400,000 of owner add-backs increased the value of the business $2.5m.

 P/L Statement  Multiple  Enterprise Value
 Sales  5,000,000
 – COGS  -3,000,000
 Gross Profit  2,000,000
 SG&A  -1,000,000
 Net Income  1,000,000
 Depreciation  250,000
 Interest  30,000
 EBITDA  1,380,000  4x  $5,520,000
 Owner Add-Backs  400,000
 Adjusted EBITDA  1,780,000  4x  $7,120,000

 

We are not suggesting that you change anything you are doing in terms of expenses you are running through the business for tax reasons. Only, that you:

  • Be aware of what add-backs are
  • Understand the impact of add-backs on business valuation
  • Keep track of these owner add-backs when selling a business

 

The team of Business Brokers at Brentwood Growth has expertise in factoring in add backs when selling a business. We know which add backs and adjustments are appropriate for your type of company. This helps to begin the process on the right foot, creating trust between the buyer and seller, and setting the correct initial value for your business from the start.

Most Popular
July 28, 2021
Selling a business can be a difficult journey. Not only…
July 6, 2021
One of the questions we are frequently asked is: ‘who…
July 5, 2021
Deciding when to sell your business is a huge decision,…
July 5, 2021
How do we determine the value of our business? A…
June 24, 2021
One of the great benefits of owning a business is…
Categories