The add-back that costs you more than it adds

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Every private business has adjustments to make before its earnings can be read fairly, and most of them are legitimate. The trouble starts when every unpleasant expense becomes exceptional. Overreach on one add-back and the buyer starts doubting the honest ones, and then everything else you’ve told them.

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The add-back schedule usually runs to about a page. The owner’s car, added back. The owner’s spouse on the payroll, added back. The legal dispute that’s finally settled, added back. The office move, added back. And a line for the consultant who rebuilt the customer database, added back as a one-off, which it was, the first time. The second year it went in as a one-off again. By the third year it’s a cost of doing business with a better name.

Every line on that page might be defensible on its own. The buyer reads the page as a whole, though, and the page is telling them something about the person who wrote it.

Why the adjustments exist at all

A buyer is paying for what your business can keep earning once it’s theirs, which is a different number from what it earned last year. Your accounts are a record of what happened. The adjusted figure is a claim about what will keep happening, and a claim needs evidence.

Private businesses carry costs that won’t survive a sale. Family members on the payroll. A car, travel, insurance, and subscriptions that belong to the owner rather than the operation. An owner’s salary that’s well above, or well below, what it would cost to replace them. Then there are the genuine one-offs: a $200,000 legal dispute that’s over for good, a relocation, a system that’s been replaced and won’t need replacing again for years.

Adjusting for all of that is normal, and a competent buyer expects it. In a serious transaction there’s often a quality of earnings review whose whole job is to work out what the business really earns, underneath what it reported. Nobody loses credibility for making the honest adjustments.

Where it goes wrong

It goes wrong when “one-off” becomes the label for anything you’d rather the buyer didn’t count.

A one-off that appears three years running is a recurring cost. Take out your own $300,000 salary because you’re leaving, and somebody competent still has to do your job; the buyer will put the cost of hiring them straight back in. Claim $400,000 of savings from changes you haven’t made yet, and expect to be asked why the buyer should pay you today for work they’ll be doing after you’ve gone. And if your biggest customer left after year end, pointing at last year’s accounts won’t bring them back.

None of that is hard to spot. Experienced buyers have seen far more creative add-backs than any owner will ever write.

Why it costs more than it adds

Here’s the part owners miss. An add-back the buyer rejects doesn’t simply come out of the number. It changes how the buyer reads every other line on the page.

Push every conceivable adjustment into the earnings and the buyer starts questioning the sensible ones as well: the family salary that genuinely won’t continue, the dispute that genuinely is over. You’ve turned your legitimate adjustments into negotiating points, and the buyer will negotiate them.

That’s the first cost, and you can measure it. Claim $2 million of earnings, have the buyer accept $1.7 million, and at six times the price falls from $12 million to $10.2 million. The multiple didn’t move.

The second cost is harder to see, and it’s usually larger. I’ve written before that the multiple is a risk score: the buyer’s private estimate of how likely your earnings are to still be there once you’ve gone. A schedule that reads like an argument is evidence about that risk. It tells the buyer that the numbers in this business bend under pressure, and that whoever produced them will push them as far as they’ll go. A buyer who has learned that doesn’t keep paying six times for everything else you’ve told them.

The line nobody believes gets priced twice: once in the earnings, and again in the multiple. That’s how an add-back ends up costing more than it adds.

A number you can’t reproduce is an opinion

There’s a quieter version of the same problem, and it catches owners who haven’t overreached at all.

Say you tell a buyer your best division runs at a 28 per cent margin. They ask for the workings. Your accounting system doesn’t report profit by division, so somebody builds a spreadsheet: revenue from one system, labour from another, customer data from the CRM, and some costs allocated by judgement because there’s no other way to do it. The three systems don’t quite reconcile.

The 28 per cent might be exactly right. The buyer just can’t establish it independently. A fact has become a management assertion, and assertions get discounted.

If your financial story depends on one spreadsheet that one person maintains and has to explain, put it on your pre-sale problem list.

The cheque-writer’s test

The fix is to interrogate every adjustment before the buyer does, and to be harder on it than they’ll be.

An add-back earns its place if it’s genuinely exceptional, if you can evidence it, and if it really does disappear on completion. It loses its place if the exceptional keeps happening, or if removing your cost just creates a replacement cost somewhere else. The last test is the one I’d apply to every line: would you accept this adjustment if you were the one writing the cheque?

Strike the lines that fail. What’s left is a smaller number, and it’s one you can defend for as long as the buyer cares to push on it. That’s the number that gets paid for.

Do it across several years rather than the last 12 months, and make sure you can explain every big movement in margin or cost before anyone asks. An explanation put together in the room, under questioning, sounds exactly like what it is.

If you’re raising money rather than selling, the investor’s accountants read the schedule the same way, and price it the same way.

If you are the buyer here: the add-back schedule tells you about the seller as well as the business. The adjustments they chose not to push are what make the rest believable, and the ones they did push show you where to look first.

What to do this week

Get the add-back schedule a buyer would see. Ask your accountant for it, or write the rough version yourself: every adjustment you’d make to last year’s earnings, with the amount next to it. Then go down it line by line with the cheque-writer’s test, and with whoever in the business knows the history of each line.

Mark every line keep, evidence, or strike. Keep is exceptional, evidenced, and gone on completion. Evidence is true, but you can’t prove it yet. Strike is anything you wouldn’t accept if it were your money.

The strike column is money you were going to lose anyway; taking it out yourself saves you the trust it would have cost. The evidence column is your work for the next six months.

The full financial rehearsal, from normalising your earnings and testing how cash follows profit to the consistency checks a buyer will run, is in Financial and Legal Essentials for Selling Your Business, free to download from the Download Vault: manolutions.com/downloads.