Add-backs are the adjustments that turn the profit in a set of accounts into the earnings figure on a listing. Some are routine and uncontroversial. Others are where a seller's optimism, and occasionally something worse, finds its way into the numbers. Because small businesses are priced as a multiple of earnings, every add-back is paid for several times over. This guide sets out the tests an add-back should pass, sorts the common ones into those that usually hold up, those that need a closer look and those that rarely survive, and then tests a fictional seller's schedule line by line.
Add-backs are costs added back to reported profit to show what a business would earn under a new owner. They raise SDE and adjusted EBITDA, so each one needs evidence.
What an add-back is for
An add-back is a cost in the accounts that a new owner would not carry, added back to profit so the earnings look as they would after the sale. The point is fair comparison. Add-backs remove the effect of one owner's personal choices, such as how they pay themselves or finance the business, and of genuine one-off events.
The words that matter are "a new owner would not carry". An add-back is only valid if the cost really stops when the seller leaves and removing it does not reduce revenue.
The stakes are easy to see. If a business is priced at an illustrative 3 times SDE, an add-back of $40,000 adds $120,000 to the price. Striking out an unsupported add-back of the same size takes $120,000 off. Few hours in early diligence are better spent than the ones spent testing add-backs.
Seller's discretionary earnings (SDE)
Seller's discretionary earnings is the yearly financial benefit a business gives one full-time working owner, before financing costs, non-cash charges and one-off spending.
Due diligence is the investigation a buyer carries out before committing to a purchase, testing the finances, contracts, legal position and operations against what the seller has described.
The tests every add-back should pass
Put each add-back through five questions.
- Is it real? The cost should appear in the accounts and be backed by invoices, payroll records or bank statements. A figure in a schedule with no trail behind it is an assertion, not an add-back.
- Will it really stop? If someone will still need to do the work or pay the bill after the sale, only the difference between the current cost and a fair market cost can be added back.
- Does revenue stay the same without it? If a cost helps win or keep customers, removing it will cut revenue too.
- Is it truly one-off? Look back over three years. A "one-off" that turns up every year, or every other year under a different label, is a running cost.
- Does it sit comfortably with the tax returns? If personal spending has been claimed as a business cost, ask an accountant whether that creates tax exposure, especially in a share sale, where the company's history comes with it. See unpaid taxes a buyer could inherit.
In an asset sale you buy selected assets of a business; in a share sale (a stock sale in the US) you buy the company itself, with its full history. The choice shapes risk, tax and what needs consent.
Add-backs that usually hold up
These are widely accepted, provided the evidence is there.
- One working owner's pay and benefits. For SDE, the salary and benefits of one full-time working owner are added back, including pension, superannuation or retirement contributions. For adjusted EBITDA, that pay is then replaced with a market salary for the role. Check the payroll records.
- Interest. Your financing will replace the seller's, so their interest cost goes. Remember that repayments on any money you borrow will come out of the same earnings.
- Depreciation and amortisation. These are accounting charges rather than cash spent in the year. They are added back routinely, but you still need to budget for replacing the assets.
- Genuine one-off costs with paperwork. Examples include legal fees for a dispute that has been settled, the cost of moving premises, uninsured repairs after a flood or fire, and the broker's and lawyers' fees for the sale itself. Check that the event is over and did not affect revenue.
- Clearly personal spending run through the business. A car used only privately, family holidays or a relative's phone contract can be added back when receipts show what they were.
Adjusted EBITDA is EBITDA after normalising adjustments, showing what a business would earn with a paid manager in the owner's seat. Larger small-business deals are usually priced on it.
Depreciation and amortisation spread the cost of long-lived assets over the years they are used. They reduce profit without any cash leaving the business in that year.
A business broker markets businesses for sale and manages the process on the seller's behalf. The broker is usually paid by the seller, mostly when a deal completes.
Add-backs that need a closer look
These can be partly valid. The answer depends on the facts.
- Family members on the payroll. If a relative is paid but does no work, their pay can be added back. If they do real work, only the amount above a market rate can. If they are paid below market, deduct the difference. See family or related staff paid off-market rates.
- Rent paid to the owner. When the owner or a related company owns the premises, the rent may be above or below market. Restate it at a market rent in whichever direction that goes, and check that you can secure a lease on those terms. See related-party transactions.
- The owner's vehicle and phone. Usually part business and part personal. Only the personal share holds up, ideally supported by a logbook or usage records.
- Travel, conferences and entertaining. Some is personal and some brings in customers. Ask what each trip produced.
- "One-off" projects such as a website rebuild, a software change, a rebrand or a recruitment drive. Many come round every few years. Spread the cost over a realistic cycle and add back only the amount above the yearly average.
- Large repairs. A big repair may be a one-off. It may also be the first of several on ageing equipment. See deferred maintenance or capital spend.
- A second owner's pay. Loupe's method adds back pay for one working owner only. If a second owner works in the business, their pay stays in costs, because you would need to replace them. Pay well above a market rate for their role may leave room for a partial add-back, and pay below it calls for a deduction. Loupe's valuation tool keeps that pay in costs as entered, so make that judgement yourself.
Add-backs that rarely hold up
Treat these with scepticism, and expect to strike most of them out.
- Unrecorded cash sales. Income the seller says exists but never put through the books cannot be verified, and if it is real it suggests income has not been declared for tax. Do not pay for it. See unrecorded cash sales.
- Savings a buyer could make. Cheaper suppliers, fewer staff or a smaller office may be real opportunities, but you would be the one delivering them. A price that already includes them pays the seller for your work.
- Revenue that should have happened. A lost contract, a delayed order or a poor season blamed on the weather. Earnings are what happened, not what might have.
- Running costs with a one-off label. Yearly marketing campaigns, ongoing consultancy, software subscriptions and bonuses that staff have come to expect are all part of running the business.
- Costs of staying compliant. Insurance, licences, accreditations and inspections have to be paid by whoever owns the business, even if the seller has let some lapse.
- Schedules that outrun the evidence. Round figures with no documents behind them, or add-backs that grow between the teaser and the information memorandum, are warning signs in themselves. See large or undocumented add-backs and figures that change between the teaser and later documents.
An information memorandum is a detailed sales document about a business, usually prepared by the seller's broker or adviser and shared after an NDA. It is written to present the business well, not to test it.
Adjustments that go the other way
Restating earnings fairly is not only about adding costs back. A careful buyer also deducts:
- one-off revenue inside the trailing twelve months, such as an unusually large single order or a grant (see one-off revenue inside the last 12 months)
- unpaid or underpaid work by the owner's family, or by a second owner paid less than the job is worth
- rent below market from a related party, which will rise once a lease is agreed on normal terms
- costs the seller has held back ahead of the sale, such as maintenance, marketing or insurance, and supplier bills paid late to flatter cash (see payables stretched ahead of a sale)
- costs a new owner will face that the seller did not, such as systems or insurance the owner went without, or a manager if you will not run the business yourself, which is the deduction adjusted EBITDA makes
Sellers rarely volunteer these. Ask about each one.
Trailing twelve months means the most recent 12 consecutive months of figures, whatever the financial year. It gives a more current view than the last set of annual accounts.
Worked example: testing an add-back schedule
Wattle Creek Coffee Supplies is a fictional Australian wholesaler that supplies coffee beans and equipment to cafés. The owner runs it full time with six staff. All names and figures are invented. The seller's schedule claims SDE of A$420,000. Here is how a buyer might test it.
| Line | Seller's figure | Tested figure | Reason |
|---|---|---|---|
| Net profit before tax | A$180,000 | A$180,000 | Reconciles to the tax return |
| Owner's salary and superannuation | A$95,000 | A$95,000 | One full-time working owner, payroll records seen |
| Depreciation | A$30,000 | A$30,000 | Accepted, van replacement budgeted separately |
| Interest on equipment finance | A$10,000 | A$10,000 | Finance to be repaid at completion |
| Owner's spouse on the payroll | A$45,000 | A$20,000 | Does the bookkeeping, which would cost A$25,000 to replace |
| Website rebuild | A$15,000 | A$10,000 | Rebuilt every three years, so A$5,000 a year is a running cost |
| Owner's vehicle | A$12,000 | A$5,000 | Logbook shows it is mostly used for deliveries |
| Trade show travel | A$8,000 | nil | Most new café customers are met at trade shows |
| Estimated unrecorded cash sales | A$25,000 | nil | Not in the accounts or tax returns and cannot be verified |
| Profit on a one-off order for a hotel opening | nil | (A$20,000) | Will not recur, so removed |
| SDE | A$420,000 | A$330,000 |
The tested SDE is A$90,000 lower than the seller's figure. At an illustrative multiple of 2.5 times SDE, that difference is worth A$225,000 of price: A$1,050,000 on the seller's figures against A$825,000 on the tested ones.
None of the rejected items proves the seller acted in bad faith. Most are ordinary optimism, and some, like the spouse's pay, are partly right. Together they still change what the business is worth, and they give the buyer specific, documented reasons for a lower offer.
Net profit before tax is what a business earns after all its costs, including interest and depreciation, but before tax on its profits. It is the starting point for SDE and EBITDA.
Evidence to ask for
Ask for evidence early, before you agree a price, while you still have room to walk away. A useful request covers:
- the seller's add-back schedule for three years and the trailing twelve months, not just the latest year
- the general ledger, so each add-back can be traced to actual transactions
- invoices, contracts or settlement documents for every one-off cost
- payroll records showing who is paid what, and for which role
- bank statements, to confirm that recorded costs were actually paid
- tax returns, to confirm the accounts match what was filed (see tax returns that do not match the accounts)
- vehicle logbooks, and any leases or agreements with related parties
The diligence document request list puts these and the rest of a typical request into one checklist. For larger purchases, a quality of earnings review by an independent accountant tests add-backs far more thoroughly than a buyer can alone.
A quality of earnings review is an accountant's analysis of whether a business's reported earnings are accurate, sustainable and correctly adjusted. It is not an audit.
How Loupe treats add-backs
Loupe's free valuation tool asks for the one-off or discretionary costs a new owner would not carry, with a prompt to include only what can be evidenced. It adds them to SDE along with one owner's pay, interest, depreciation and amortisation, and shows the build-up line by line so you can see exactly what you entered.
The quality of the records also moves the multiple. With the tool's starting weights, owner-prepared records alone take 15% off the multiple, while reviewed or audited accounts, or a completed quality of earnings review, add 5%. The tool also flags a profit margin above 50% outside software and content businesses, which can be a sign that costs have been added back too freely. See margins far above industry norms.
A Loupe dossier goes further on a specific business. It sets the listed figures beside normalised ones and lists the add-backs to test, with each finding marked as verified, as listed or estimated. What's in a dossier describes the sections. However you test the figures, treat this guide as general information, and take advice from a qualified accountant before you rely on any earnings figure for a purchase.