Add Backs: What Are They?

During due diligence, a prospective buyer of an auto repair shop noticed that an office assistant was listed on the payroll. But he'd visited the business as a customer and had never seen anyone working in the office. When inquiring about this, he learned that a "salary" of $1,500 per month was being paid to the seller's sister-in-law, and that she was listed as an office assistant, but didn't actually work at the company. The buyer was troubled by this discovery. Also confusing was the seller's assertion that auto expenses, such as gas and insurance charged off as business costs, should be added back to profits.

These are just two examples of the many questions and sources of confusion that can surface when trying to understand the actual costs to operate the business. The confusion comes about because many, if not most, sellers attempt to show as little income as possible to reduce taxes. When it's time to sell, the business owner has the opposite objective to show as much earnings as possible.

When the buyer looked into what the seller was saying, he learned that the owner's sister-in-law came in on evenings or weekends to balance the company check book, verify that all parts ordered were charged against repair orders, compare vendor statements with individual invoices, handle payroll, sales tax and related duties. And while it was true that the seller was charging the business for his personal auto expenses, it also true that the car was used for business activities such as picking up parts and taking customers to their home or office.

These explanations, however, sometimes raise more questions. It's up to the careful buyer to question every item on the income statement and ask questions such as:

• - Is each itemized expense necessary in order to operate the business properly?
• 
  - Is the listed total for each item the actual expense, or is the real cost lower or higher?
  
  

A well prepared adjusted income statement anticipates buyer questions and clearly defines what expenses are not necessary for efficient management of the business. But not every seller knows how to provide that information in a way that's easy to understand and not everyone is willing to engage in full and complete disclosure.

Part of the business brokers's job is to question the seller about each item to determine if it is a “true business expense” necessary to run the business. A competent business broker will review the seller’s income statements and “recast” the numbers by adding back the “non-essential expenses” that were paid through the business in order to arrive at an Adjusted Net Income.

The smart business buyer does not accept, without question, the figures listed in the financial statements, but does some investigating to learn what the figures actually represent. Buyers will find that 98% of small business owners have some type of add back and should not walk away from the business if they are satisfied with the seller’s explanations of the add backs.