Two years ago, we published an article related to “add-backs” to business free cash flows and their importance to value when planning your exit. The information has proven to be very helpful to a number of clients and prospective clients of our firm so we decided to revisit this topic.
Business value “add-backs” refer to certain business expenses that are truly one-time in nature, are incurred due to the present owners community relationships or are otherwise not necessary to the ongoing operations of the business. The reason that identifying these expenses while thinking about business value in certain exit scenarios is so important is because any business is only worth what a future owner expects to receive in benefits from owning your business (i.e. net expected future free cash flows).
Keep in mind, when making decisions about what types of expenses you have your business incur and what expenses you incur personally, there is a point at which business “perks” become too liberal given the tax code and construct that governs them. While that line may be drawn differently for every individual, we strongly encourage each business owner to work with a CPA trained in business-related issues along with their Wealth Planner and Business Exit Planner as they determine how to balance these competing issues and craft their business financials and cash flow. (Note that the type of eventual exit you are pursuing also needs to be a factor when determining how to manage what expenses the business incurs and does not.)
Examples of Typical Add-Back Expenses
While there really isn’t a “typical” anything when trying to understand a business’ value (because every single one is entirely unique!), there is a general bank of add-backs that apply to many businesses. The list below is by no way all-inclusive and cannot replace the advice of your CPA and Exit Planner, but is instead meant to provide some examples as you consider your business financials.
- Owner Salary above a “market” rate
- Children or other family members on payroll at an above “market” rate given the type and amount of work being performed for the business
- Any owner perks that are not 100% business related (owner cell phones, certain travel, company vehicle)
- Items that are truly one-time in nature (do not fool yourself about periodic expenses that are recurring but just not every year)
- Meals and entertainment that exceed a typical stipend or are not necessary to maintain company cash flow
- Owner benefits that are not customary (life insurance in excess of what is needed for “key man” coverage, as an example)
- Charitable Contributions made due to an owner’s personal charitable goals (this may or may not be an add-back depending upon your business entity type)
- Lease payments for business-occupied real estate (many times business owner controlled as well) in excess of a fair market rate
The ‘Normalization Process’ to Get to the Company’s True Cash Flow
The process of adding back these expenses is called a ‘normalization’ process. Done properly, this process will identify all of the personal and non-recurring expenses within the business and will add them back to free cash flow to show a future owner the true earnings potential of your privately-held business.
When considering an exit from your privately-held business, it is important to remember that it is your responsibility to demonstrate the future earnings power of your business to your future owner. By understanding the normalization process and working with your trusted advisors you may be able to substantially improve the potential value that a future owner is willing to pay you for your business.
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