What are add-backs?
"Add-backs" are expenses that are not directly critical to current operations and are thus added back to a company's reported earnings to estimate Normalized EBITDA, which is used to estimate business value.
Why normalizing EBITDA is important
Most businesses have some amount of expenses that are not directly critical to operations.
Since "the market" (hypothetical prospective buyers) will remove any non-critical expenses to realize full earning potential, reported earnings are adjusted to estimate what the value of the business may be to the market. This is the process of "normalizing" earnings.
Without normalizing earnings by including add-backs, your client's business value may be underestimated. Likewise, if add-backs are overstated this may lead to overestimates of valuation.
Add-back examples
Examples of add-backs include:
- Profit sharing or incentive compensation plans. This may include expenses around pension plans, 401K profit sharing, deferred compensation plans, and profit sharing incentives.
- Excess owners compensation expense above what a replacement salary would cost. Owners work hard to build income generating businesses and have every right to pay themselves well as a result! In the event they transition ownership, the business will have to pay someone to replace the owner's functional role. The difference between what the business would pay a replacement of the owner and what the owner is earning today may be considered an add-back expense in some cases.
- Strategic and/or one time expenses not directly tied to current operations. This may include salaries, technology investments, or professional fees associated with future growth initiatives or one time projects.
- Discretionary expenses. Any expenses that are considered at the owner's discretion and not critical to maintaining current operations. This may include charitable contributions, excess travel costs, country club fees, and culture-building type of expenses.
Items typically not included in add-backs
Not every payment or expense qualifies as an add-back. The goal is to reflect the business's sustainable earnings without overstating profitability. An add-back should represent an expense that actually reduced earnings and is not necessary to sustain normal business operations.
- Owner distributions (including K-1 distributions): Distributions to owners are not operating expenses and do not reduce EBITDA. Unlike salaries or bonuses, there is nothing to add back.
- Loan principal payments: Principal payments reduce outstanding debt, not earnings, and therefore do not qualify.
- Equipment purchases: Capitalized purchases of equipment, vehicles, or other assets are recorded on the balance sheet and should not be added back.
- Normal operating expenses: Employee wages, benefits, rent, and other necessary expenses generally do not qualify unless they are demonstrably excessive or nonrecurring.
- Expenses already included in EBITDA adjustments: Interest, taxes, depreciation, and amortization are already accounted for in EBITDA and should not be added back twice.
Request an estimate of "add-backs" from clients
It's best to work with your client or their accountant to understand if they have any of these types of expenses and consider if an appropriate adjustment is needed to normalize earnings.
Identifying which expenses used to normalize EBITDA is a nuanced and complex task and is a difficult exercise to conduct by looking at the typical business tax return alone.
Asking clients about what expenses are not critical to operations is the best way to capture this data.
Example email
Subject: Non-operational / Discretionary expenses Hello, We're working on a valuation estimate for you and want to make sure the current value of the business is not underestimated. Can you help us understand how much of your annual business expenses would reasonably go away if the business hypothetically changed hands? When estimating business value, expenses not directly critical to current operations are typically added back to earnings to better reflect the business's ability to generate earnings. Including a list of expenses that are commonly added back to earnings during valuation estimates for you to consider: - Profit sharing or incentive compensation plans. - Compensation you pay yourself that is above what you might pay your hypothetical replacement after you transition. - Salaries, technology investments, or professional fees not directly critical to current operations. - Discretionary expenses like charitable contributions, excess travel costs, country club fees, and culture-building or leadership retreats. Thank you!