The following is a guest post from Quiet Light.
There is a great deal that goes into determining the value of an online business. Especially for entrepreneurs that aren’t financially minded, the calculations can seem overwhelmingly complex. It’s easy to lose track of certain variables.
Add-backs rank among the most commonly overlooked or misunderstood elements in business valuation, but they’re also among the most important.
What Are Add-Backs and Why Are They Important in Business Valuation?
An add-back is any expenditure that is non-critical to a business’s operations and which will not carry over to a buyer. Although they’re part of the business’s operating budget, most of them do not typically directly drive revenue, promote business growth, or drive profitability. What they do affect is cash flow.
Add-backs are critical in ensuring your profit & loss statements are as accurate as possible. Otherwise, instead of showing prospective buyers how much your business actually makes, they’ll see a distorted picture that portrays your profits as lower than they actually are. This will very likely reduce your business’s valuation, and consequently its sale price.
In other words, if you fail to calculate add-backs, you won’t receive a fair value when you sell.
How to Identify Add-Backs in Your Business
There are actually several different categories of add-back, which range from simple and obvious to subtle and complex. It’s important to understand each separate category of add-back. It’s equally as important to identify what doesn’t qualify as an add-back.
Level 1 Add-Backs
A level 1 add-back is best described as something that directly benefits the business’s owner. Salary is the most obvious one, but Small Business Association Loans also qualify. Note that when calculating the owner’s salary, don’t forget to include taxes and benefits.
Other level 1 add-backs include:
- Business meals
- Personal expenses related to the business
- Interest on loans
- Estimated quarterly tax payments
- Retirement contributions
Level 2 Add-Backs
Level 2 add-backs typically cover one-time expenses that don’t provide any obvious or immediate benefit to the owner. They include investments in intellectual property, expenses related to a lawsuit, and one-time purchases of professional services such as bookkeeping. Depreciation and amortization of purchased assets also qualify as a level 2 add-back, with one important caveat
You can only add back the value of an asset that depreciates over time, and it must be calculated based on the asset’s estimated remaining lifespan.
Level 3 Add-Backs
Level 3 add-backs are a bit more complicated and difficult to understand. Whereas other add-backs do not directly contribute to revenue or profitability, level 3 add-backs are typically directly related to business operations. They include, but are not necessarily limited to:
- Website design. Depending on how frequently you redesign your website, you can either add back the full cost of the redesign or a portion of the cost.
- Association fees. Partnerships and funds such as mastermind fees are typically enrolled in by the owner. This means that, although they typically influence a business’s sale value, costs don’t carry over from one owner to the next.
- If you’re handling the cost of running your business through a cashback credit card or something similar, the rewards count as an add-back. Note that it’s crucial that you’re able to justify to a prospective buyer why this should qualify as an add-back.
- Employee salary. Not every employee’s salary will qualify as an add-back. However, if you’re overpaying an employee or you know for certain an employee will not remain at the company post-sale, you might either adjust the employee’s salary to reflect what someone might actually make in that role or else add the entire salary back.
- Reduced cost of goods. If you’re working with a supplier or service provider and manage to negotiate with them to provide you with a better price, you can retroactively apply your cost savings per unit as an add-back.
Things That Don’t Qualify as Add-Backs
It can be tempting to treat everything as an add-back and try to find cost savings wherever you look. You need to be careful not to go overboard, however. There are certain situations that do not qualify, including:
- Inventory costs
- Marketing & advertising
- Second owner’s salary
- Salary of essential staff, under any circumstances
- Utilities and maintenance
How to Calculate the Value of an Add-Back
Add-backs are closely related to two other critical valuation metrics—the SDE and business multiple. Add-backs increase a seller’s discretionary earnings, which are then multiplied by the multiple to arrive at a final valuation. For instance, imagine a business where the SDE is $150,000 at a 3x multiple. If that business’s add-backs total $3000, that would increase the final sale value of the business by $9,000. .
There are multiple other factors that influence the numbers above, as well:
- Profit margins
- Revenue sources
- Year-over-year growth
- The state of the economy
- The state of your industry
- Growth opportunities
- How clean/organized a business’s books are
- The business’s transferability
- Single points of failure—for instance, reliance on a single supplier to such an extent that if that supplier were to terminate their relationship, the business would sink.
Add-backs can greatly increase the final sale value of a business. Unfortunately, calculating them tends to be incredibly complicated for even an experienced entrepreneur. At the end of the day, your best bet is to work with a qualified Advisor who understands your industry and sector.
A qualified Advisor, such as those at Quiet Light, can help you identify add-backs, including those that are commonly missed by owners. In doing so, they can help you maximize the sale value of your business, while also helping you find the perfect buyer in the process. In other words, whether you’re selling your business in the immediate future or considering an exit a few years down the line, it’s very likely worth your time to bring in an expert—both for the valuation and for the sale.