When a company makes the decision to buy or sell another business there are many factors involved. The worth of the business to be purchased needs to be evaluated accurately. This is often done by calculating the EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation). These numbers can be used as a baseline to compare the value of different businesses to assess what a fair selling or purchase price would be. Sometimes expenses are added back to a company’s profits and this is called an add back.
What Are Add Backs?
In mergers and acquisitions, an add back is an expense that’s added back to a company’s profits, most often the EBITDA. Its sole purpose is to improve the profit situation of the company. One could say the EBITDA value becomes an adjusted EBITDA with the add backs included.
In theory, add backs are supposed to be one-time expenses incurred by the current business owner. These expenses are expected to go away when the company is sold to the new owner since they pertained directly to the previous owner and they aren’t something that the new owner is likely to have to cover in the future. If an expense shows up on a company’s income statement year after year, then it’s not considered an add back, but a regular and recurring yearly expense. Add backs have no true economic value in the performance of a business; they’re essentially tax deductions.
What Types of Add Backs Are There?
There are several types of add backs related to the operation of a business:
- Owner’s compensation: many owners give themselves salaries and bonuses and these numbers are likely to change when ownership is transferred, as the new owner won’t necessarily pay themselves the same salary.
- Taxes and benefits: suppose the owner of the business takes out health insurance on themselves as well as their spouse and children. If the spouse and children don’t work for the business, then it’s considered a legitimate add back.
- Severance pay or lawsuit settlements: while these are rare, they’re a legitimate add back and sometimes come up during the course of a sale.
- Personal expenses: these might include a company car, monthly dues to different clubs, travel expenses, meals or mobile phone accounts. Anything that doesn’t affect the performance of a business can be considered a personal expense.
Why Are Add Backs Important When Selling a Business?
Add backs are important for a business sale because it gives the buyer a broader overall picture of what the business will be worth and the amount of cash flow the new owner can expect to receive. The new owner might decide to handle expenses in a similar fashion, but they might also want to allocate funds to different types of expenditures. Removing subjective expenses from the profits by adding them back allows a potential owner to understand just how much profit they can really expect.
The current owner can also demonstrate the earning power of the business using the add back value as part of the bigger picture, especially if they recently leveraged company profits on business expenses that weren’t critical to day-to-day operations.
When add backs are factored in with other values, including EBIT and EBITDA, a buyer interested in purchasing a business gets a clearer picture of the true cash flow of the company, and by extension, how financially stable it is.
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