Summary: Add backs are specific business expenses that can be added back to the seller's discretionary earnings (SDE). Consequently, add backs can increase the SDE. Add backs are important in small business acquisitions because they affect the SDE, which ultimately determines the company's valuation. In this article, we cover:
- What is an add back?
- Examples of add backs
- How do add backs affect small business valuations?
- An add back example
- Do add backs affect your financing options?
- Should you get a Quality of Earnings Report?
1. What is an add back?
Add backs are adjustments to the sellers discretionary earnings that enable buyers to determine what profits they can expect from a business acquisition. Adjustments are made by adding back certain expenses that are not expected to be the new owner's responsibility. The objective of these add backs is to provide an SDE that is a more accurate representation of profits. This adjustment allows for a more "accurate" company valuation.
2. Examples of add backs
The two most common add backs are owner benefits and certain one-time expenses. Let's look at these add backs in more detail.
a) Current owner's benefits
The obvious benefits owners get from the business are their salary and the company's profits. However, many owners receive additional benefits from the company. These include:
- Certain memberships (e.g., clubs, associations)
- Some traveling expenses
- Company car
These costs reduce profits but are considered "optional" since they are unnecessary to run the business, and the buyer could spend the money differently. Consequently, adding them back to the SDE provides a better picture of earnings.
Companies with multiple owners who receive a salary can only use one of the owner salaries to adjust the SDE. The other salaries must remain as expenses. This is because the new owner can benefit from only one of the salaries. The salaries from other owners need to be used to cover the salaries of new employees hired to replace them after the acquisition.
b) One-time expenses
Companies also have certain expenses that occur only "one time." These one-time expenses reduce profits but they are not considered regular costs of the business. If these expenses occurred during the years used to calculate the SDE, they could be added back. Examples include some litigation costs, facilities remodeling, or one-time marketing promotions.
3. How do add backs affect small business valuations?
Add backs have an impact on the valuation of a small business. They can increase or decrease of valuation of a small company based on whether they are added or taken away. Negotiating add backs can be a source of disagreement between the buyer and the seller.
Each party in the negotiation has a competing interest. Sellers want the highest possible SDE. They have an incentive to include as many add backs as possible because it increases the company's price. On the other hand, buyers want the lowest possible SDE and have incentives to remove add backs.
4. An add back example
The effect that add backs have on the company's valuation depends on the size of the add backs and the multiple used in the valuation. Let's assume a buyer wants to acquire a laundromat. Laundromats are usually valued at 3 to 5 x SDE plus inventory. To keep the example simple, we assume there is no inventory.
Let's assume that the laundromat seller provides an SDE value of $450,000. This figure puts the valuation range of the laundromat between $1,350,000 and $2,250,000. After careful review, some add backs are removed, and the SDE is adjusted to $420,000. Consequently, the new valuation range gets adjusted to $1,260,000 to $2,100,000.
Depending on the exact multiple you use, a $30,000 reduction to the SDE decreased the valuation by $90,000 to $150,000. Ultimately, this adjustment translates to a 6.67% reduction in price.
- SDE of $450,000
- Valuation: $1,350,000 to $2,250,000
After adjustments, you get the following:
- SDE of $420,000
- Valuation: $1,260,000 to $2,100,000
- Valuation difference: $90,000 to $150,000 (reduction)
- Equivalent to a 6.67% price reduction
5. Do add backs affect your acquisition financing options?
Add backs can affect your ability to get your acquisition financed. It may be hard to see this at first because the effect is indirect. However, business valuation is one of the most important criteria that lenders review when underwriting a deal. As we showed in the previous example, add backs affect the valuation because they adjust the SDE. Consequently, they can affect your ability to get the necessary funding to close the deal.
Let's explore how add backs affect each component of the acquisition package. Most small companies are acquired using a combination of SBA-backed financing, an equity injection, and seller financing.
a) SBA-backed financing: up to 90% of the transaction value
Most small business acquisitions use SBA-backed financing. SBA-backed loans can finance up to 90% of the transaction value, which allows buyers to use a leveraged buyout structure for the acquisition. However, there is one important caveat. Lenders finance transactions only up to the value they consider to be reasonable.
b) Equity injection: 10% of the transaction value
The equity injection is the amount of cash that the buyers contribute to the transaction. At a minimum, it has to be 10% of the transaction value. These funds must come from the buyers and cannot be financed.
c) Seller financing: 0% to 20% of acquisition value
Lastly, seller financing is provided directly by the seller. Sellers prefer to offer the least amount of financing as possible. However, buyers often require sellers to provide some financing for the transaction. Consequently, many transactions have a small seller financing component.
How add backs affect financing
Let's look at a simple example of how a relatively small add back can derail a transaction. Keep in mind that real-world transactions are never this simple. Assume that a buyer and a seller have contentious negotiation about $50,000 in add backs. Ultimately, the buyer agrees to the add back, and the parties settle on a transaction price of $2,050,000. After all, relative to the size of the deal, $50,000 doesn't seem like that much.
After discussions with the lender, the buyer discovers the transaction is $50,000 higher than what the lender is willing to finance. Consequently, the disagreement in the add back changed the amount of money you need to buy the business. The transaction is now in jeopardy.
There are a few ways to handle this situation. The buyer could threaten to walk away if the seller doesn't lower the price by $50,000. This is always an option. However, if the buyer wants to acquire the business and the seller won't budge, the buyer has to come up with an extra $50,000 to bridge the gap.
A buyer with sufficient resources could put an additional $50,000 into the equity injection. This is an easy fix that seldom happens. In reality, few buyers can afford a higher equity injection. Most buyers commit the majority of their life savings to the transaction and have few additional resources.
Alternatively, the seller could add the $50,000 to the amount of the seller financing package. Doing this would also bridge the valuation gap. The point of this example is to show how $50,000, which is relatively small compared to the purchase price, can affect your ability to structure a financing package and create problems later on.
6. Should you get a Quality of Earnings report?
A Quality of Earnings (QoE) report is a due diligence tool that helps buyers evaluate the target company's financial health. They are typically written by CPAs with experience in acquisition due diligence. The report tries to identify problem areas that could affect the business, including:
- Accounting problems
- Financial risks
- Unusual transactions
- Concentration problems
- Related transactions
- Sustainability of revenues
These reports can be useful during due diligence negotiations because they help you identify add-backs more accurately. Consequently, they will help you determine a more realistic SDE. We believe most small business buyers should get a QoE report. They can be expensive, so the transaction size has to justify buying the report. If you decide to get a QoE report evaluation, work with a company with experience in small business acquisitions, ideally in the target company's industry.
Add backs affect the company's valuation and, ultimately, your return on investment. Buyers should work with a financial professional, such as a CPA, to ensure the SDE metric you use in the acquisition reflects the company's actual earnings and true potential.
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This information should not be considered legal or financial advice. Given the complexity of business acquisitions, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide you with the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.