When buyers value a lower middle market company, they usually start with EBITDA (earnings before interest, taxes, depreciation and amortization). The EBITDA on your financial statements is rarely the number they’ll pay for, though. Most owners run some expenses through the business that a new owner won’t have, and most companies have a few unusual costs in any given year. Adjusting for those items is what’s known as add-backs, and the adjusted EBITDA is what buyers typically apply a multiple to.

That makes add-backs one of the most valuable parts of a sale, and one of the most scrutinized. At a five times multiple, every $100,000 of add-backs that holds up is worth $500,000 of value.

What Add-Backs Are

An add-back is an expense that shows up in your financials but won’t continue under a new owner. Most fall into two groups.

Owner-related expenses. These are costs tied to you rather than to running the business:

• Compensation and bonuses above what it would cost to hire someone to do your job
• Personal expenses run through the company, such as a vehicle, travel or insurance
• Perks a buyer won’t keep. Chicago Bears season tickets are a classic example.
• Family members on payroll who don’t work in the business

One-time business expenses. These are real business costs that won’t recur:

• An ERP implementation
• One-time legal expenses, such as a lawsuit that’s been resolved
• Costs of closing a location or exiting a product line
• Costs of the sale itself, such as M&A advisory, legal and accounting fees

Negative add-backs. Adjustments work in both directions. If the business is missing someone it needs, a buyer will deduct what it would cost to hire that person. A common example is an owner who also serves as the controller. Below-market rent paid to an owner-controlled building is another, which we covered in Owned Real Estate in a Business Sale.

Being upfront about negative adjustments builds credibility. Buyers will find them anyway.

What Add-Backs Aren’t

Buyers draw a firm line between one-time costs and the normal costs of doing business. An expense doesn’t qualify because it was unusually large one year, or because it’s inconvenient to the earnings story.

Repairs and maintenance are a good example. Equipment breaks every year, just not the same equipment. The same goes for overtime in a busy year, a big trade show and anything else you’d expect to come back, even if irregularly.

Pushing weak add-backs usually costs more than it gains. When a buyer finds a few items they don’t believe, they start discounting the whole schedule.

Credibility Is Everything

Every add-back will be tested in diligence. A buyer’s accountants will ask for invoices, payroll records, contracts and bank statements, and they’ll trace each amount back to the general ledger. This is often a central part of a buyer’s Quality of Earnings review. Expect every penny to be checked. If an add-back can’t be supported, it comes out of EBITDA, and the price usually comes down with it.

A few practical steps help:

• Build the add-back schedule before going to market, before a buyer asks for it.
• Tie each item to specific source documents.
• Explain each item in a sentence or two: what it was and why it won’t recur.
• Be conservative. A shorter list that holds up is worth more than a long one that gets picked apart.

Build Your Add-Back Schedule Early

Add-backs can meaningfully increase what a buyer will pay, but only the ones you can prove. Owners who start gathering support a year or two before a sale are in a far better position than those trying to reconstruct it during diligence.