Selling a business involves various financial adjustments, and one of the most crucial is the concept of add backs. These adjustments help sellers present their business’ true profitability by removing certain discretionary or one-time expenses.
Add backs play a significant role in determining the business’s value, and ensuring that potential buyers see an accurate financial picture. However, misusing add backs or failing to document them properly can lead to disputes, legal complications, and lost deals.
This article explains what add backs are, which expenses qualify, the risks involved, and how sellers can properly justify them when selling a business.
What Are Add Backs in a Business Sale, and Why Are They Important?
When selling a business, buyers look at its financial performance to determine its value. One key metric they use is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation). Add backs adjust EBITDA by removing non-essential or non-recurring expenses, providing a clearer picture of the business’s profitability.
Why Are Add Backs Important?
- Reflects True Profitability: Many businesses have expenses that are unique to the current owner. Removing these expenses helps showcase the business’s actual earning potential.
- Increases Business Valuation: A higher EBITDA often leads to a higher sale price, making add backs a crucial tool for maximising the business’s worth.
- Standardises Financials for Buyers: Buyers need to compare businesses on an equal basis. Add backs help adjust for owner-specific expenses that wouldn’t apply to a new owner.
- Improves Negotiation Leverage: A well-documented list of add backs can strengthen the seller’s position during negotiations by demonstrating the true earning capacity of the business.
However, sellers must be cautious. Overstating add backs or including improper expenses can lead to disputes, loss of buyer trust, or even legal action.
Which Expenses Can Be Considered Legitimate Add Backs?
Not all expenses qualify as legitimate add backs. To be considered valid, an add back must be:
- Non-recurring: One-time expenses that will not happen again under new ownership.
- Owner-specific: Costs that only apply to the current owner and will not transfer to the buyer.
- Documented: Clear records proving the expense’s nature and legitimacy.
Common Types of Add Backs
- Owner’s Salary and Benefits: If the current owner takes a high salary, bonuses, or personal benefits (such as a company car), these can often be added back, especially if the new owner will pay themselves differently.
- One-time Legal or Professional Fees: Legal costs, consulting fees, or accounting expenses that were necessary for a specific reason (such as a lawsuit or restructuring) but won’t be recurring.
- Personal Expenses Through the Business: Some owners run personal expenses (e.g., travel, meals, memberships) through the business. These can be added back, provided they are properly documented.
- Non-business-related Expenses: If the company has covered costs unrelated to business operations (such as a personal vehicle registered under the business), these may qualify as add backs.
- Family or Non-essential Staff Wages: If family members are on payroll but do not perform a business-critical role, their salaries could be added back.
- Depreciation and Amortisation: These accounting expenses do not directly affect cash flow, making them common add backs.
- One-time or Extraordinary Expenses: Unusual costs like major equipment repairs, legal settlements, or rebranding efforts that are unlikely to reoccur under new ownership.
What Cannot Be Considered an Add Back?
- Recurring operational costs (e.g. rent, utilities, marketing expenses)
- Necessary staff wages (e.g. employees vital to business operations)
- Tax obligations (buyers will need to account for ongoing tax liabilities)
Being transparent about add backs ensures a smoother sales process and builds buyer confidence.
What Are the Legal Risks and Common Disputes Over Add Backs?
Add backs can become a point of contention between sellers and buyers. If not handled properly, they can lead to disputes that delay or derail a business sale.
Legal Risks of Add Backs
- Misrepresentation: If a seller includes questionable add backs, they risk being accused of inflating earnings. This can lead to legal disputes or even claims of misrepresentation.
- Tax Compliance Issues: Some add backs may attract scrutiny from the Australian Taxation Office (ATO) if they involve personal expenses being claimed as business deductions.
- Breach of Sale Agreement: If financial adjustments are not disclosed properly, buyers may claim a breach of contract after the sale is completed.
- Disputes Over Future Profitability: Buyers may challenge add backs if they believe the expenses will continue under new ownership, potentially lowering the purchase price or causing the deal to collapse.
Common Add Back Disputes
- Personal vs Business Expenses: Disagreements on whether an expense was genuinely personal or necessary for operations.
- Owner’s Salary Adjustments: Buyers may question whether they will need to hire someone else at the same or higher salary.
- One-time Expenses: Buyers may argue that certain “one-time” expenses could reoccur.
Proper documentation and transparency can help mitigate these risks and prevent potential legal battles.
How Should Sellers Properly Justify and Document Add Backs?
To ensure add backs are accepted without dispute, sellers must provide clear and verifiable documentation.
Steps to Properly Justify Add Backs
- Maintain Detailed Financial Records: Keep invoices, receipts, payroll records, and financial statements that show the nature of each add back.
- Use a Clear Explanation: Clearly outline why each add back qualifies, providing a written explanation with supporting evidence.
- Work with an Accountant or Business Sale Lawyer: Having a professional validate add backs adds credibility and ensures compliance with Australian laws.
- Disclose Early in the Sale Process: Presenting add backs upfront helps avoid last-minute disputes and builds trust with potential buyers.
- Ensure Consistency Across Financial Documents: Add backs should align with your financial statements, tax returns, and profit-and-loss reports.
Best Practices for Presenting Add Backs
- Create an Add Backs Schedule: A spreadsheet listing each adjustment, its amount, and supporting documents.
- Be Conservative: Only include reasonable and justifiable expenses.
- Prepare for Buyer Questions: Expect scrutiny and be ready to explain each adjustment with facts.
By properly documenting and presenting add backs, sellers can increase buyer confidence and improve their chances of securing a higher sale price.
Maximising Your Business Sale with Smart Add Back Strategies
Add backs play a crucial role when selling a business, as they help reflect its true profitability. However, they must be used carefully, ensuring they are legitimate, well-documented, and legally compliant.
Misusing add backs can lead to disputes, delays, or even legal consequences. By understanding which expenses qualify, being transparent with buyers, and working with professionals, sellers can increase their business’s valuation and make the sale process smoother.
If you need expert legal guidance when selling your business, Walker Pender is here to help. Our experienced business sale lawyers ensure your financial adjustments are legally sound and support a fair business valuation. Contact us today for a consultation and safeguard your business sale.
