One of the most challenging aspects of valuing a small business is Recasting Financial Statements using cash flow adjustments, also known as “add-backs”.
Larger businesses tend to have CPA-reviewed or even audited statements and adjustments may be limited to officer compensation or bonuses.
However, for smaller businesses, it’s no secret that owners try to limit their tax liability by expensing personal or “non-operational” items through the business. The concern for outside parties is typically twofold: (1) will a lender accept this and (2) can it be verified?
Add-back acceptance is a grey area, most likely falling under prudent lender policy. Although there is no right or wrong answer, I would ask the following questions to help determine if the addback is reasonable from a financial point of view:
- Is it verifiable? Add-backs such as unreported income or family wages being paid from cash cannot be verified and therefore should not be considered.
- Was it expensed on the tax return or financial statement being analyzed? There are some expenses on an internal P&L that never made it to the tax return…whether a tax deduction (instead of an expense) or elimination by the CPA, you can only addback something that has been expensed. Typical non-expenses may include health/life insurance and distributions.
- Does the expense have any impact on revenue or efficiency? For example, I would typically not add back advertising expense, as it would be virtually impossible to know how much revenue was generated from the advertising.
- Is the add-back strategic in nature or directly related to the buyer? Fair market value is typically used as the standard of value. This standard of value is based on a hypothetical buyer/seller scenario; therefore, we must assume a hypothetical buyer. Add-backs that are specific to the buyer or buyer's company are not typically used. Real estate appraisals don’t have different values for different buyers, why should business valuations?
- Is it truly non-recurring or one-time? For an internet company, is a redesign of a website a one-time expense? Most likely it is an expense that happens every 3-5 years and should be treated as a capital expenditure. Therefore, if the redesign cost $50,000 and needs to happen every 5 years, I would addback the $50,000 for the year of the redesign, but deduct $10,000 for all years analyzed.
The above are just a few questions we typically ask ourselves or the sellers, buyers, or CPAs involved. However, as mentioned, there is no right or wrong answer and simply falls under the “reasonableness” category and ability to support the add-back. Now that you’ve decided to use an add-back, how can it be verified? The following steps are what we typically use in due diligence:
- Have the seller or CPA give the actual dollar amount (not rounded). Sellers are known for “guestimating” or rounding numbers. We require the actual amount that was expensed on the tax return or financial statement being analyzed.
- Have the seller or CPA explain why the expense is non-recurring. You notice I didn’t say “personal”…CPAs will typically call it non-recurring or non-operating. We typically ask for a detailed explanation of why this expense will not continue with the sale.
- Have the seller or CPA isolate where the add-back was expensed on the tax return or financial statement being analyzed. For instance, if it’s a one-time repair of the facility’s roof, we want to know it was expensed under line 9 of the tax returns called “repairs and maintenance
- Have the seller or CPA provide the general ledger that shows this was expensed under that category and matching the amount under #1 above.
- In our experience with the lenders, the above due diligence is usually sufficient when reasonably supporting add-backs. I would suggest starting this process early with the seller and seller’s CPA. Addbacks can be frustrating, but are a very important part of small business valuation. The more information the appraiser has, the better he or she will be informed and the more accurate the appraisal.
By: Steven A. Mize, is the Managing Partner at GCF Valuation, Inc. and PeerComps, Inc. Steve is an accredited Senior Appraiser with an extensive background in the business valuation.
Also Read: Recasting Financial Statements: A Crucial Step In Preparing Your Business For Sale