Add Backs: Defining Sellers Discretionary Income When Buying A Small Business
The prospective buyer of an auto repair shop for sale in Central California noticed, while conducting due-diligence, that an office assistant was listed on the payroll. But he'd visited the business as a customer and had never seen anyone working in the office. When inquiring about this, he learned that a "salary" of $1,500 per month was being paid to the seller's sister-in-law, and that she was listed as an office assistant, but didn't actually work at the company.
That's an "add-back" and it should be included with net income the seller said.
The buyer was troubled by this discovery. Also confusing was the seller's assertion that auto expenses, such as gas and insurance charged off as business costs, should be added back to profits.
These are just two examples of the many questions and sources of confusions that can surface when trying to understand the actual costs involved with operation of a business. The confusion comes about because many, if not most sellers attempt to show as little income as possible to reduce the taxes that have to be paid. Then, when it's time to sell, the business owner has the opposite objective, wanting to show as much earnings as possible to justify the price being asked for the business.
The typical way of resolving this dilemma is for the seller to point out the costs charged off to the business but not really necessary to operate.
These explanations, however, sometimes raise more questions than they answer.
When the buyer who was investigating the auto repair business for sale looked into what the seller was saying, he learned that although there was no one physically present in the office during business hours, it was necessary to have someone handling office work. The sister in law came in on evenings or weekends to balance the company check book, verify that all parts ordered were charged against repair orders, to compare vendor statements with individual invoices, handle payroll and sales tax responsibilities and take care of related duties.
And while it was true that the seller was charging the business for his personal auto expenses, it also was the fact that the car was used for needed business activities such as picking up parts and taking customers to their home or office.
A well prepared adjusted profit and loss statement anticipates buyer questions and clearly defines what expenses on the operating statement are, and what are not necessary for efficient management of the business. But not every seller or business broker knows how to provide that information in a way that's easy to understand. And not everyone is willing to engage in full and complete disclosure.
It's up to the careful buyer to question every item on the income and expense statement. And to ask questions such as:
- Is each itemized expense necessary in order to operate the business properly?
- Is the listed total for each item the actual expense, or is the real cost lower, or higher than what has been entered in the books?
- What was the ratio of the amount in each expense item to the total of all expenses for the last complete year? How does that figure compare to the percentages in prior years? If there is a substantial change in any single category, what is the reason?
The smart business buyer does not accept, without question, the figures listed in the P&L (or tax returns) and financials of a company being considered, but does some investigating to learn what the figures actually represent.
Some typical "add-backs" utilized frequently to compute adjusted net income/sellers discretionary cash/cash flow include:
- Owner's Annual Salary
- Annual Net Income
- Owners Pension
- Owners Health Insurance Premium
- Amortization
- Depreciation
- Interest Expense (typical are loans that will be paid off when the business is acquired)
- Rent/Mortgage Payment (if the business is being acquired with an SBA Loan)
- One Time Business Expense (an annual expense the new owner will not have in the future)
- Salary Expense Of Family Members (who don't actually work at the business)
That's an "add-back" and it should be included with net income the seller said.
The buyer was troubled by this discovery. Also confusing was the seller's assertion that auto expenses, such as gas and insurance charged off as business costs, should be added back to profits.
These are just two examples of the many questions and sources of confusions that can surface when trying to understand the actual costs involved with operation of a business. The confusion comes about because many, if not most sellers attempt to show as little income as possible to reduce the taxes that have to be paid. Then, when it's time to sell, the business owner has the opposite objective, wanting to show as much earnings as possible to justify the price being asked for the business.
The typical way of resolving this dilemma is for the seller to point out the costs charged off to the business but not really necessary to operate.
These explanations, however, sometimes raise more questions than they answer.
When the buyer who was investigating the auto repair business for sale looked into what the seller was saying, he learned that although there was no one physically present in the office during business hours, it was necessary to have someone handling office work. The sister in law came in on evenings or weekends to balance the company check book, verify that all parts ordered were charged against repair orders, to compare vendor statements with individual invoices, handle payroll and sales tax responsibilities and take care of related duties.
And while it was true that the seller was charging the business for his personal auto expenses, it also was the fact that the car was used for needed business activities such as picking up parts and taking customers to their home or office.
A well prepared adjusted profit and loss statement anticipates buyer questions and clearly defines what expenses on the operating statement are, and what are not necessary for efficient management of the business. But not every seller or business broker knows how to provide that information in a way that's easy to understand. And not everyone is willing to engage in full and complete disclosure.
It's up to the careful buyer to question every item on the income and expense statement. And to ask questions such as:
- Is each itemized expense necessary in order to operate the business properly?
- Is the listed total for each item the actual expense, or is the real cost lower, or higher than what has been entered in the books?
- What was the ratio of the amount in each expense item to the total of all expenses for the last complete year? How does that figure compare to the percentages in prior years? If there is a substantial change in any single category, what is the reason?
The smart business buyer does not accept, without question, the figures listed in the P&L (or tax returns) and financials of a company being considered, but does some investigating to learn what the figures actually represent.
Some typical "add-backs" utilized frequently to compute adjusted net income/sellers discretionary cash/cash flow include:
- Owner's Annual Salary
- Annual Net Income
- Owners Pension
- Owners Health Insurance Premium
- Amortization
- Depreciation
- Interest Expense (typical are loans that will be paid off when the business is acquired)
- Rent/Mortgage Payment (if the business is being acquired with an SBA Loan)
- One Time Business Expense (an annual expense the new owner will not have in the future)
- Salary Expense Of Family Members (who don't actually work at the business)
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