Add-backs that survive underwriting and add-backs that die in it

Every business for sale comes with a recast profit and loss. Net income is low because the seller runs personal costs through the company; the broker adds them back and presents the real earning power. Some of those add-backs are legitimate and will be accepted. Some will not, and the ones that fail are usually the largest.

The difference is not whether the add-back is true. It is whether it is provable from a document a third party produced.

A recast, itemised

• Reported net income: 96,400
• Interest: 31,200
• Depreciation: 48,900
• Amortisation: 6,000
• Owner salary: 145,000
• Owner health insurance: 14,400
• Two family members on payroll who do not work in the business: 52,000
• Personal vehicles: 11,700
• One-time legal settlement: 38,000
• Discretionary travel and meals: 9,200

Claimed discretionary earnings: 452,800. Deduct a market manager at 88,000 to replace the owner, and the figure a buyer would use is 364,800.

Which of these hold

What the contested items are worth

Documented add-backs total 341,900, and after the 88,000 manager replacement, 253,900 of defensible cash flow. Contested items total 110,900.

At the 3.2 multiple in an illustrative letter of intent, those contested add-backs are worth 354,880 of purchase price.

The effect on financing is larger. At a 1.25 coverage requirement and an illustrative 9 per cent over ten years:

• Cash flow of 364,800 supports about 1,919,862 of debt.
• Cash flow of 253,900 supports about 1,336,220.

A difference of 583,642 in borrowing capacity, produced entirely by which documents exist.

How to test an add-back before it costs you

Run each line through four questions in order.

1. Is it on a document the seller did not create? A W-2, a bank statement, an invoice from a third party, a settlement agreement, a vehicle registration. Self-prepared schedules are a starting point, not evidence.
2. Does it recur? Pull the same line for three years. A cost that appears every year is not one-time no matter what it is called.
3. Does the business still need it after closing? The test is not whether the seller enjoyed the expense. It is whether the revenue survives without it. A sponsorship the owner likes might be the reason two accounts stay.
4. Would it be added back by someone who is not being paid on the sale price? A useful discipline when you are reading a broker's recast.

What to do with the analysis

Do not argue the add-backs line by line in the first conversation. Build two columns — documented and contested — and make your offer on the documented column, with a mechanism for the contested one.

The mechanism is usually one of these:

• Price reduction for anything that fails the document test.
• A seller note sized to the contested amount, so the seller carries the risk of their own claim.
• An earnout measured on the specific metric in dispute, which is the right structure when the disagreement is about future performance rather than past cost.
• Escrow for a defined period where a contested cost may recur, such as pending litigation.

Before your first offer

1. Ask for three years of tax returns, not one, and reconcile the recast to each year.
2. Ask for the general ledger detail behind every add-back over a threshold you set — 5,000 is a reasonable line.
3. Ask for the payroll register, so you can see exactly who is paid what.
4. Build the documented and contested columns yourself and share the documented total with your lender early. An underwriter told about the contested items by you is a different conversation from one who finds them in the general ledger.
5. Subtract owner replacement and maintenance capital spending after the add-backs, never before, and make sure the multiple you are discussing applies to the same measure the seller is quoting.

Refuse to proceed on a recast you have not reconciled to a tax return. It is the cheapest hour of diligence available and it routinely moves the price by more than the business earns in a year.