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You’ve decided you want to sell your business — and you’re excited about it. You’ve poured years of effort into building your empire, you have buyer interest or even an offer on the table, and for the first time in years, you can see the light at the end of the tunnel. A part of you wants to just power through, seal the deal and ride off into the sunset.
Not so fast. While it can feel tempting to rush into the sale, doing so without properly calculating seller’s discretionary earnings (SDE) can often leave tens of thousands or even hundreds of thousands of dollars on the table. Most likely, your business will be sold as a multiple of SDE, and SDE equals net income plus add-backs. Most of us are intimately familiar with that first number, but the second number is the secret sauce behind lucrative exits.
Add-backs are owner benefits and non-recurring expenses that are on your current financial statements, but will not carry through when a new owner takes the reins. Digging for them — and adding them “back” below your net income line in your exported P&L — is vital if you want to command top dollar for your business.
I’ve helped thousands of people sell their online businesses over the years, and not factoring in add-backs to a company’s valuation is one of the biggest mistakes I see owners make. In my book The EXITpreneur’s Playbook: How To Sell Your Online Business For Top Dollar By Reverse Engineering Your Pathway To Success, I go into detail with plenty of numbers and examples on why ignoring or rushing through add-backs could cost you the equivalent of your child’s college education. Here’s a rundown of what add-backs are and the three levels of add-backs most relevant for entrepreneurs.
How add-backs work
Again, add-backs are owner benefits and the non-recurring expenses that do not carry forward when your buyer takes over your business. By listing out these adjustments, you show your prospective buyer that your business’s expenses will actually be lower when they take over the company. These finer accounting details are rigorous, but by providing them, you’ll actually build trust and rapport in the negotiation process.
Some add-backs are obvious. For example, with owner-operator businesses, if an owner takes a big salary or the company covers your health insurance, these are “owner benefits” and considered add-backs. Other add-backs are more nuanced and could be as granular as credit-card cash-back monies or converted points or recent changes in your per-unit cost of goods (COGS). It ultimately depends on the setup and structure of the business, and no two deals are ever alike.
It’s good to be both rigorous and discerning with add-backs. Too little diligence will leave money on the table, but nickel-and-diming too much or having sloppy math can strain your relationship with your buyer and potentially cause a deal to fall apart. Here are three levels of add-backs to keep in mind as you prepare your business for a future sale.
Factor in your obvious add-backs
Most owners give themselves a few perks as a result of owning their business — these can qualify as add-backs. Your most obvious add-backs to start with are owner payroll, owner health insurance, owner retirement contributions, charitable contributions and intangible assets such as amortization and depreciation.
Even though these add-backs are obvious, owners often still make mistakes that leave them in a sticky situation when it’s time to negotiate a deal. For example, when it comes to owner salary, this number assumes a workweek of 40 hours or less. Are you actually working only 40 hours a week as the owner of the business? If the answer is no, you open the door for your buyer to renegotiate; they will point out that more than one person will be needed to replace you. This results in higher projected operating expenses — and an adjusted offer after due diligence.
Charitable contributions can also be a tricky add-back. Sure, the next owner of the business doesn’t have to make those same charitable contributions, but what if your company’s charitable efforts are inherently linked to how the product is marketed and sold? Charitable donations can be an add-back, but only if you’ve shown that removing that expense doesn’t negatively impact total sales. That’s why you need data and a long-term plan.
Take inventory of one-time expenses from the past year for more add-backs
Your seller discretionary earnings (SDE) are calculated from your company’s previous 12 months of financial statements. If you had one-time expenses during this period that won’t carry over, those expenses count as add-backs and can help you increase your valuation.
For example, if your business took on one-time legal expenses or filed for new trademarks, patents or copyrights, those are add-backs. One-time new graphic designs or equipment purchases? Yep, those are add-backs too. If your accounting is a mess, know that you need clear books to get the best value for your business. Hire an ecommerce bookkeeper and do two to three years of back bookkeeping if you have to to get everything up to speed — these one-off bookkeeping expenses would also count as add-backs.
Personal expenses embedded in your P&L could be considered add-backs as well since they won’t carry through, but you want to be careful here. Are the business meals you’re expensing actually being used for business? Your buyer will go through every line of your financial statements with a fine-toothed comb; adjust your financial spending accordingly so that your numbers are transparent and clear.
Dig really deep and leave no stone unturned
This final category of add-backs can get really specific, but when we’re trying to get the best valuation possible, every dollar counts.
Take, for example, expenses that don’t happen every year, but rather every few years. A common example is a website redesign or a brand refresh. You might sink $10,000 into this effort, but it’s something you only do every 3-5 years. Because it is not recurring annually, the majority of this expense would be considered an add-back.
Another example that is big with entrepreneurial owners is professional-development expenses, such as courses, masterminds or business coaching. The seller chose to invest in these resources to make himself or herself a better entrepreneur — that was his or her choice. If the buyer wants to take on these investments for himself or herself as well, this is also a choice. Since it’s not an essential expense for the business, the investment could count as an add-back.
Selling your business can be one of the most exciting and lucrative days of your entrepreneurial career. But to set yourself up for success, you need to have your ducks in a row, and a trusted advisor in your corner can help you get there. Start thinking less like an entrepreneur and more like an EXITpreneur today, and a hefty cashout can be closer than you ever imagined.