Stop Killing Your Company’s Exit Value
I have purchased several online and offline businesses over the past thirty years and I have read hundreds (or maybe thousands) of business broker packages about companies for sale. One thing virtually all include are “addbacks.”
What are Addbacks?
Every business broker presentation has historical financial data from QuickBooks (or other accounting software), including profit and loss statements and balance sheets. There may also be tax returns, whether prepared by the company or a paid accountant. Presentations typically include three years of historical data and partial year to date. In addition, presentations often include a second set of historical data adjusted for addbacks. These are adjustments made to represent what the financials would look like if the buyer purchased the business.
Common addbacks include interest, depreciation and amortization, and owner salary. If the sale is an asset sale, the buyer will most likely purchase a “clean company” that is debt free. The buyer won’t assume the debt and will not have to pay interest. Likewise, depreciation and amortization are just accounting charges and non-cash expenses and will not continue after the sale. The buyer may have its own depreciation and amortization, but again these are non-cash expenses and can be useful to reduce tax obligations. Whatever the seller was accruing on these charges isn’t relevant to the buyer.
The owner's salary is not so clear cut. Does the owner work full time at the business or is he/she laying on the beach and collecting a paycheck? Can the business really survive without the owner working there? One must ask a lot of questions and perform significant due diligence about the owner’s role in the company before accepting this as an addback. In addition, one must ascertain the market value of replacing the owner. As an example, if the owner works full time at the business and draws a $50,000 paycheck, but a replacement would require a $100,000 salary, then the income presented should actually be reduced by $50,000. The addback is only legitimate if the owner really has no role in the company, or partially if he/she could be replaced by someone with a lesser salary.
What Other Addbacks May be Presented?
Now we get to a variety of “discretionary” expenses. Other addbacks include expenses that have no impact on the company and the buyer can eliminate. These include owners who expense their car, phone, home internet, travel, meals, medical insurance, retirement account and more to the business. We are not going to address how legitimate these expenses are for tax purposes, only the impact on the buyer. One must evaluate each one and determine whether the expense really is “discretionary.” The cell phone may not be if the business has no separate phone number. Medical insurance and retirement accounts should be evaluated in conjunction with the owner's salary. The car may not be discretionary if the owner’s role involves using the car for business purposes. Same with travel and meals.
How do Addbacks Impact the Sale Process?
The most egregious addback I have ever seen involved a t-shirt manufacturer I was looking to purchase several years ago. Four investors had purchased the company and then decided to resell it. I was never quite sure how much involvement any of the four had in the company, but I do know they treated it like an ATM paying their personal expenses. The income statement was loaded up with personal expenses, including four luxury car leases, one for each owner. If memory serves me correctly, they were BMWs. The income statement was impossible to evaluate, and I walked away without making an offer. Their shortsightedness in using the company for probably illegitimate tax writeoffs cost them a legitimate buyer.
The Importance of a Clean Income Statement
More recently I encountered the opposite situation. I was a financial consultant for the buyer on a deal to purchase a medical practice, and I was in charge of financial due diligence. The QuickBooks financial statements matched the tax returns over the last three years almost to the penny. The addbacks were very limited and a small percentage of the total sales and income reported. The owner’s salary, health insurance and retirement plan were clear and the owner’s involvement and replacement cost easily calculated. Other things like attorney fees and broker fees for the sale were clear. My digging deeper found only one thing, some personal cell phone charges. Due diligence was very simple and quick and I recommended to the buyer to go through with the sale.
The addbacks turn a $40,000 income into $180,000.
Preparing an Exit Strategy in Advance
If you are considering exiting your business sometime in the not too distant future, the best exit strategy for maximum value is to prepare in advance. If you have been charging personal expenses to the business, eliminate them 1 to 3 years before you list the business for sale. This way you will have 1 to 3 years of cleaner tax returns that will create buyer confidence that you have a solid business. In the short term you may have to pay higher taxes, but the difference in exit value should dwarf that and the business should sell quicker.
