In order to show a buyer the true benefit from owning a business, adjustments are made to the income statement to show the true owner benefit. This key number goes by many names.
- Adjusted Net*
- Adjusted Net Income*
- Adjusted Net Operating Income*
- ODI (Owner’s Discretionary Income)
- Discretionary Earnings
- SDE (Seller’s Discretionary Earnings)
- SDCF (Seller’s Discretionary Cash Flow)
- Cash Flow
Cash Flow is arrived at by “starting with your net (before tax) profit. Then, add back any payments made to the owner, interest and any depreciation of assets.”
BizBuySell Glossary
Discretionary Earnings: The earnings of a business enterprise prior to the following items: income taxes, non-operating income and expenses, nonrecurring income and expenses, depreciation and amortization, interest expense or income, one owner’s entire compensation, including benefits and any non-business or personal expenses paid by the business. Seller’s Discretionary Earnings (SDE)and Seller’s Discretionary Cash Flow (SDCF) and Adjusted Net are other terms used.
IBBA Glossary
NOTE: Adjusted EBITDA is used in the M&A word for larger transactions. It is the same concept but does not include salary add backs for any owners.
* Add backs are used to adjust net operating income, not net income. This intentionally ignores other income and expenses, which are one-time, unusual or atypical items such as income from the sale of a piece of equipment.
Example 1
Profitable
- Net operating income is $5,000
- Owner’s salary is $70,000
- Owner’s personal car expense is $10,000
- Bookkeeping expense is $30,000 paid to family member and should have cost $15,000
- Equipment depreciation is $20,000
Adjusted net operating income is $120,000
($5,000+$70,000+$10,000+[$30,000-$15,000]+$20,000)
This is a profitable business with significant value to the owner despite low profitability on the income statement.
Example 2
Unprofitable
- Net operating income is $5,000
- Owner did not pay himself a salary
- Zero personal expenses run through business
- Landlord provided $5,000 of rent forgiveness due to COVID
- No depreciation, interest or amortization
Adjusted net operating income is $0
($5,000-$5000)
The negative add back of $5000 for rent means this owner was working for free AND the business was not profitable.
What are Add Backs When Evaluating a Business?
Add backs are adjustments to the income statement where certain expenses are added back to the profit of the business. This is done to show the true owner benefit by removing non-cash expense items, expenses that are unlikely to appear again, expenses that benefit the owner but are not required for the business, and expenses unique to the current owner.
The add back may be for the full amount of the expense item or a partial amount. Examples of partial amounts would be 50% of the cell phone expense or the difference between rent paid and market rent. While most add backs are positive, some are negative. For example, one-time relocation expenses are added back to show higher profit since they won’t re-occur, while below market rent becomes a negative add back for the difference to reduce the profit to reflect the buyer’s true rent costs.
| Non-Operating | Non-Cash | Non-Recurring | Discretionary |
|---|---|---|---|
| Loan Interest (buyer may have no loan or different interest) | Depreciation | Facility Relocation Expenses | Expenses for personal auto used partially, rarely, or not at all for the business |
| Expenses for a related / other business | Amortization | Government grants or relief | Above/below market wages (plus payroll tax, insurance, benefits) for owner/family member |
| Other Expenses (below the Net Operating Income line) – see below | Legal, financial, consulting or professional services that are not ongoing | Travel | |
| Technology upgrades | Entertainment or club dues | ||
| Bad debt | Charitable contributions | ||
| Reduction in tariffs | Above/below market rent/real estate expenses to landlord or real estate business owned by Seller | ||
| Reduction in staff no longer needed |
Add backs are expenses added back to profit defined as Net Operating Income (NOI). All the items between NOI and Net Income are other revenue and expenses. They are categorized as other since they are not regular or recurring.
Other income and expenses are not regular or recurring. Therefore, we omit them rather.
What are Not Considered Add Backs?
Add backs can be debated. Typically there are buyer-suggested add backs, seller accepted add backs, and lender accepted add backs. Buyers who present a lengthy list of add backs or unusual add backs will meet resistance and may lose the confidence of the buyer. Especially troubling are partial add-backs on expense items that are difficult to sort out. A partial add back on office supplies may indicate personal spending on the business account. Several of these types of partial add-backs or large dollar amounts of this type are red flags. On the other hand, a partial add back from rent not equal to market rent is typically understandable and acceptable.
The following is a conservative guideline when it comes to marketing add backs. Some marketing add backs are legitimate such as a one time web design.
Marketing, even if it is one time or experimental, is never an add back.
The following are not add backs:
- failed marketing
- owners’ salaries (and benefits) above and beyond one full time salary
- recent cost-cutting of critical items such as marketing or salaries
- meals and entertainment for employees that is regular and expected as part of the business culture
- banks will not accept any income not on the tax return
- buyers will not accept cash income that is not documented
- personal expenses on a company credit card
Acceptable Add Backs for Buyer and Lenders
For the purposes of a loan, lenders are pretty clear and generally uniform across the board on what they will and will not accept, including depreciation, amortization, interest on loans/financing, owners retirement contributions, salary for non working family member, and one owner salary.
While this chart allows for uncertainty with the yellow cells, even the green and red cells may be subject to debate. Brokers can help Sellers align with Lenders and Buyers.
Add backs can often be partial, or may depend on additional information. For example, auto, travel, entertainment and cell phone expenses may receive modest partial consideration with proper documentation. Small immaterial sums may be omitted.
Non-recurring add backs must be verified as non-recurring over long periods of time. How long is subject to discussion and negotiation between buyer and seller.
Still other add backs may have different treatment from an SBA valuation perspective and a bank lending perspective. For example, a reduction in staff for positions no longer required may be considered as an add back by a lender, but an SBA valuation will not consider it.
For lenders and buyers, documentation is key for any add backs to be considered. This includes W2’s, one-time expenses, financial reports, tax returns and contracts. Buyers may even want to audit credit card and bank statements and accounting, point-of-sale, or business software systems.
Adding Value to Your Business by Reducing Add Backs
Reducing perks which are discretionary expenses to your business will make your business more profitable. When it comes time to sell, a more profitable business is worth more, often by a factor of 2-3 times for main street businesses and even more for larger businesses. The extra money received from the sale may more than offset the tax savings from these discretionary expenses. to see an example, read Simple Ways to Add Value to Your Business for Sale.