Owner add-backs explained: what's fair and what's a red flag

The profit on a small company's tax return usually isn't the number a seller talks about. Sellers, brokers and buyers use owner earnings instead: profit plus what the owner pays themselves, before loan payments and taxes. The difference between the two is a list of adjustments called add-backs, costs on the books that wouldn't continue under a new owner or that aren't really costs of running the company.

Add-backs are legitimate in principle. They're also where asking prices get inflated, because every dollar added to earnings adds about three dollars to a price at 3 times earnings. This post will help you tell the two apart.

You'll need the documents first. If you haven't requested them, see what financial documents to ask for.

How owner earnings are built

Start with the profit on the tax return, then add back items in a few categories:

• What the owner takes. The owner's salary, the payroll taxes on it and their benefits. These are added back because owner earnings is the money available to pay you and your loan.
• Financing and accounting costs. Interest on the seller's loans (you'll have your own loan, counted separately) and depreciation, a yearly accounting deduction for equipment bought in the past, not cash spent this year.
• One-time costs. Something that genuinely won't happen again.
• Personal costs. Spending on the owner's personal life that ran through the company.

Here's a hypothetical HVAC company, as a seller might present it:

Item	Amount
Profit on the tax return	$160,000
Owner's salary	$100,000
Payroll taxes on the owner's salary	$7,000
Owner's health insurance	$14,000
Interest on the seller's loans	$8,000
Depreciation	$30,000
One-time legal settlement	$15,000
Owner's personal vehicle	$9,000
Owner earnings, as presented	$343,000

Every line might be fair. Now look harder.

• Depreciation. It isn't cash spent this year, but the company's vans and equipment wear out. If keeping the fleet running will take about $25,000 a year in replacements, that's real cash going out, and adding back all of the depreciation pretends it isn't. Subtract the replacement cost.
• The legal settlement. If there was a similar claim two years earlier, it's not one-time. It's a cost of doing this kind of work. Take it back out.
• The vehicle. If the owner drives that truck to job sites and you'd need one too, it's a business cost, not a personal one.

Make just the first two corrections and owner earnings drop to $303,000. At 3 times earnings, that's the difference between a price of about $1,029,000 and about $909,000: $120,000, from two lines.

Add-backs that usually hold up

With documents to support them, these are generally reasonable:

• The owner's pay, benefits and payroll taxes, for one owner. If the owner does two jobs, say running the company and working as the lead technician, and you'll only do one, subtract the cost of hiring someone for the other.
• Interest and depreciation, with depreciation offset by realistic equipment spending, as above.
• Truly one-time costs, like a move, a rebuild after a storm that insurance didn't cover, or a lawsuit with no history behind it. Ask for the invoices.
• Family on the payroll who don't work in the business, if you can confirm they don't and you won't need to replace them.
• Rent above market when the owner also owns the building and charges the company extra. Add back only the amount above a fair rent.

Wishful add-backs and red flags

• Unreported cash. "We take in more than shows on the returns." That isn't an add-back. You can't verify it, a lender won't count it, and the seller is telling you the tax returns are wrong.
• "One-time" costs that happen every year. Look at three years of returns. A different one-time cost each year is just a cost.
• Skipped maintenance. An owner who stopped replacing equipment or fixing the building ahead of a sale has raised profit for a while. That's not an add-back; it's a bill you'll pay later.
• Jobs you'd have to refill. Adding back the salary of a manager who left last year makes sense only if you truly won't need one.
• Future improvements. "If you just raised prices" or "if someone did some marketing" is your plan, not the company's earnings. Don't pay the seller for it.
• A long list of small personal items. Personal costs aren't deductible business expenses under IRS rules, so a long list means the returns are less reliable than they look. Raise it with your accountant.

Adjustments that go the other way

A fair review also subtracts. Watch for:

• Rent below market paid to an owner who owns the building. After the sale, you'll pay a fair rent.
• Unpaid help. If a spouse keeps the books for free, you'll need to pay someone to do it.
• Related companies charging too little. If the owner's other business supplies materials or services at a discount, you'll pay the full price after the sale.
• Underpaid long-time employees who may expect a raise from a new owner.

How lenders treat add-backs

An SBA lender starts from the company's financial statements and tax returns, checked against IRS transcripts. The lender can make adjustments, including for the seller's discretionary spending, owner pay, one-time income and equipment spending the company hasn't been funding. But the lender has to justify every adjustment in writing, and adjustments without that support don't count. Changes based on owner pay also have to be backed by a look at your whole financial picture, showing you can meet your personal obligations on the salary you plan to take.

On purchases of $3 million or more, the SBA requires a quality of earnings report: an independent financial professional's review. It has to identify and document every add-back, including owner pay that's above or below market, payments to related parties and deferred maintenance (repairs put off for later). The lender then uses that report's earnings.

The practical test is simple: if you can't show a lender the document behind an add-back, assume it won't count. For how the lender's math works, see SBA loans for buying a business.

What to do this week

• Build an add-back worksheet with four columns: the item, the seller's amount, the proof, and the amount you accept.
• For every add-back, ask, "Where does this show up in the tax return, and what's the document behind it?"
• Look at three years side by side, so one-time items that repeat stand out.
• Have an accountant who works on business purchases review your worksheet before you make an offer.