Add-Backs 101

Mike Harvath  00:04

Hello and welcome to this week’s Shoot the Moon podcast broadcasting live in direct from revenue rocket world headquarters in Bloomington, Minnesota. With me today is my partner Ryan Barnett. As you guys know, I’ve been a rocket is the world’s premier growth strategy and M&A advisor for IT services companies. And today, Ryan, we’re talking about Add-backs.

Ryan Barnett  00:28

Yeah. Hey, Mike, thanks for having us on. And let us say a quick thank you to our listeners here. We’ve had some great interactions last few weeks that helped us understand our audience a little bit better, and where were they are seeing pain or where they’re seeing growth within the tech enabled services business a lot that I thank you to our listeners. And if you’re new here today, we really dive into areas that are pretty specific to the mergers and acquisition process, as well as growth strategy tactics within tech enabled services business. So application integration firms, application developers, manage servers versus service providers and resellers, cybersecurity firms and alike, are really where our focuses. And as Mike mentioned, we’d love to talk a bit about Add backs today. And to define this a little bit, when you take a look at your revenue and profit per year, you typically are going to come up with the big calculation is revenue, that’s just how many sales that you’re gonna have. And the second calculation really is typically what we’re looking at is what we’d call adjusted EBITDA. And the adjustment is really what we’re talking about today, and how that matters to if you’re a buyer and evaluate an EB X or B, if you’re seller, and you’re looking to potentially increase your your profit by adding back some some expenses that were one time in nature. So Mike, help us out what’s a what’s a common vernacular for add backs? And then what are add backs in our industry?

Mike Harvath  02:10

Well, you know, typically, when you do a valuation for tech enabled services business, it’s built on a multiple of EBITDA or earnings before interest, taxes, depreciation, and amortization. And as you can imagine, if you’re a seller, you know, you want to optimize your EBITDA. So you can maximize your valuation. Now, oftentimes, if you’re a small business owner, you may run things through your business, like discretionary expenses, to be more tax efficient, in short, to be able to have legitimate you have one time expenses or legitimate business expenses are that border on what I’ll call owner benefit or personal benefit for the owners. And these are discretionary expenses that should someone buy your business, they would not continue. In a good example, that is, let’s say a car lease, right? A lot of our clients that run businesses, if it’s a small, relatively small business, it is run as what’s called a pass through entity from a tax perspective. So it could be an LLC, or an S corp, where your income passes through to your personal tax return. And as a result, in order to be tax efficient, you typically may add some of these owner benefit type expenses to your business. And, and those get added back to EBITA. And thus enhance your valuation. And so like I said, a car leaves might be a good example of one of those other things that may, you know, some of the discretionary expenses around. You may have, for example, a box or do some entertainment with clients or you may legitimately have some expenses that maybe you do an off site meeting with your board that, you know, also has some benefit for the owners. Some of the things as one time or owner benefit type expenses get added back to EBITA.

Ryan Barnett  04:42

Yeah, I think that’s a great start, Mike, it’s before we get too much into specifics. I just want to make sure that we understand a few tenants here. One the expense in an add back, front adjusted add back to your profit here. And again, this is really the only impact that it’s had backhand is on the valuation of the business. But if you look at this, and you’re adding your ticket net income, and you’re adding back your depreciation, while the reason why you’re adding that back, is that, you’re typically going to have a debt free cash free debt free resolution, and you’re going to extinguish that debt. So the depreciation that’s with that, that you have been paying on gets added back to that profit. So what we’re talking about here is above and beyond that, interest, taxes, depreciation and amortization. And we’re looking at at specific things that would really not continue after the transaction is closed. And I can’t stress the criticality of that, it’s something that it was Go is going to be done, and will continue to be done after a transaction, you if it’s going to continue on, they cannot be considered in that add-back. I’ll give you an example here. If you’re, you have, let’s say a marketing team who has been executing, okay, but perhaps not up to what you think, or maybe even had a failed campaign was very likely that a firm will continue to have marketing investments in the future. So even though you may have had a bad campaign in the past, it’s you can’t get a buyer is going to look at that with scrutiny. Because likely they’re going to make marketing investments in the future. The same would be if you if you’re running a business, and you’re the CEO of the business, and you’re leaving the firm, well, there’s a good chance that you may have your whole salary as a as an add back issue, you would no longer be contributed. But if a another general managers needed, you still have to account for some kind of management. So the big thing here with a recurring or even repeat expenses in the future cannot be considered a net back. Anything to add on that might sound that premise?

Mike Harvath  07:16

Well, I think you’ve done really well, Ryan.

Ryan Barnett  07:19

Yeah. So if we, if we dig into some categories, and this is something where is a seller, we think you should take a few liberties. And at least understanding the categories of addbacks. Some of them are very, very clear. One of them that we just mentioned, really sits around that above market compensation for for an owner. So oftentimes, as a CEO, you may have a premade collect salary. But if that salary is above what you would pay another CEO, the rest of that salary be considered an add back, we see that it’s an add back a very, very clear eyed bag, that’s accepted, I would say almost every single time the benefits that you might give yourself, the additional benefits that you may not have is continuing person tax fringe benefits, and you can have above market contributions. And the benefits of those are all pretty clear add backs, and we’ll get started most of the time. The other ones that are very clear, are any kind of let’s say you’re going through a transaction, and you use an advisor, like revenue rocket, anything that is considered within that the, let’s say a retainer period of the sale, that would actually all be contribute to the sales, it pay, it literally pays to have an m&a advisor as that won’t get paid back at whatever the multiple of the EBITA that you have. So any kind of expenses that are related to an m&a advisor. And sometimes we often see things like coaching or management coaching management, people involved that are above and beyond what may be considered, quote unquote normal in the larger company that oftentimes times its back. So really start to look at who you’re talking to, or who you’re using permanent advisory standpoint. Mike, what about things like subscriptions, let’s say you use a marketing database and or you’re using perhaps you have a research database that maybe borders on. Nice to have. How do you treat some of that hurt as far as addback?

Mike Harvath  09:42

Well, I think it’s an important you know, it’s an interesting question because the yeah back sort of perfectly clear, are kind of easy to manage. It’s where you get into the gray area that makes it tougher. I’ll make one point on compensation too, just to tie this out. You know, if you’re paying yourself above market compensation. And you’re going to add that back. Certainly that’s a clear add back. But you should understand that if a buyer model is your business with that change in compensation, that you shouldn’t expect to be paid your previous salary or compensation level post transaction, if you’re staying not likely, you’re modeling your compensation that will be paid post transaction, because ultimately, that was an add back to even so you need to be a little bit careful with how you manage, you know, above market compensation, particularly, and most importantly, if it is your plan to sell in versus sell out and stay on post transaction. And that’s most important long term. As far as things like subscriptions and club memberships and things that are somewhat gray. You know, certainly, I guess the best litmus test we always use, and you mentioned earlier, Ryan was, you know, will this expense need to continue post transaction? Yes or No, you need to make a decision, right? Is it fundamental to the way you run the business today? Or is it simply a nice to have. And if it’s a nice to have, and it’s not required to run and operate the business, then for certain, you could assume that it would be in the benefit of the buyer, and the seller to cut that expense moving forward post transaction. And you would thus optimize profit, the buyer would get a faster return. I mean, all those things seem to make sense. I think in many ways, it has to do with, with the buyer, right? And their propensity to understand and feel whether or not this particular discretionary expense is needed is actually needed. We’ve seen some sellers attempt to add back things that are core and fundamental to the business operation. And that’s a real challenging thing to add back. Because you have to ask the question, well, if you didn’t eat it, then why did you not cut it while you are running the business and owning the business? And you have to make a justification for why you might not need that function in the business. So I think you have to be pragmatic about thinking about add backs like this, and really ask, is this going to continue or doesn’t need to continue to post transaction and what it needs to continue if you’re a standalone entity, because certainly buyers get synergy savings based on who they are. And those savings go to the buyer. So what I mean by that is, let’s say you don’t need as much back office support, as maybe you have today. As a standalone entity. Well, those synergies go to the buyer, because they already have a back office that maybe could handle some of the workload, they’re going to get that synergy. You can’t say, Hey, we’re not going to need an accounting team, or we’re not going to need an operations team. Because once you buy our business, you know, you’re not going to need that. Well. Not really, I mean, you can’t have those things back. Because if you’re a standalone entity, you sort of have to use the standalone entity LEDs to determine the efficacy of whether that expense could be cut or not on a go forward basis.

Ryan Barnett  13:48

Yeah, I think that’s that’s a great site as a standalone, this is what you would pan out the owner benefit does come into play. And some of this owner benefit might be things like we see a lot of people who will have children or spouses or family members in the business at that family. It’s advantage advantageous from a tax perspective to do that. But if the family member is not continuing after perhaps you leave the business, that is something that could be considered an add back. How unless they are doing something critical path in which they have to be there we call it business continues.

Mike Harvath  14:34

Yes, for sure.

Ryan Barnett  14:36

Yeah. Some other things that may the need to look at and some aspects that we’ve seen more frequently lately, have been rent changes. So many people have have taken the debt to the advantage of reducing the their rent expense as we move to more remote workplace workforces. So you can take a historical look back at what that rent may have done, and how much in how much that may change from, from going forward. You might see some utilities due to rent explorations. It’s small, but you may may see things seem like that are non recurring rent taxes. Those are things that are associated with not just the building or the the rent itself, but anything around that. Mike, what, what about a potential add back on bonus programs for employees? We’ve seen a number of scenarios here. And and some of them if they there’s a little bit of a nuance here of the bonuses for the executive, or if the bonus offers a an employee. But can you walk us through a little bit what some of those bonus programs might look like? is in terms of an add back?

Mike Harvath  16:00

Yeah, I think, you know, bonus programs for, you know, the business across the board, are challenging to cut in at back. I think senior executives might be a little an exception, but let’s talk about them in more general terms. You know, people have come to rely upon a bonus program over a period of years and your business is structured in a certain way. If a buyer were to eliminate that I’ve seen as a pay cut, right? And generally, you know, an employee has a lot of money, you know, in their mind, they’re concerned about, you know, you move in their cheese if you’re gonna sell the business, and then ultimately have them have some unforeseen, negative consequence. Right, everybody’s sort of worried about that. Now, I don’t know whether you’re paying your employees over a market or not. I don’t know that bonuses and bonus programs are an appropriate add back across the board. And I would say you certainly could argue for people who are senior team members or partners, or maybe they’ve gotten a profit sharing plan in the business pursuant to their role. And, you know, maybe they’re going to get a portion of the buyout proceeds, or they’re going to have some other benefit from playing that senior role in the business. You know, it’s possible that they could, you know, be okay. But it seemed, are a cut to that bonus program. But I think in general, if this is part of compensation, and it’s part of how you align interests, with your compensation plan that, you know, cutting bonuses and trying to put those into add backs to fluff up your EBITA to enhance your evaluation is probably a bad idea.

Ryan Barnett  18:06

I think that you’re spot on. Same goes within if there’s perhaps something that maybe unscrupulous behavior that was in the past that you found, are there let’s say you just did something wrong, and someone gave away $100,000 for the hardware where they could not? I mean, it’s rare to see this, but it could happen. Is this something where if you have some mistakes in the business, is it possible for someone to take a look back and, and change or add some of that back to historical profit levels?

Mike Harvath  18:45

Yeah, I mean, I think certainly, it’s a short answer is it depends, right? It depends on the nature of that. You have to sort of look at the business and say, what is its historical run rate profitability, adjusted profitability, you could make an argument that, you know, we stubbed our toe on this, and it shouldn’t have happened, and thus, we should add it back. But as a practical matter, you know, a buyer would have the argument, but you did make that mistake, and it did impact profit, right. And so if you didn’t have the appropriate controls in place, you know, too bad for you, right? So it’s not, I can’t give your benefit for something that you screwed up, as it relates to looking at profitability. I think more importantly, however, is to look at what improved controls may be in place now. So that doesn’t occur again, and then beyond that, you know, how do you on a go forward basis look at realizing profit? Because any buyer is going to look hard at what is my return rate on this investment, and what can I expect from a profitability perspective? So, you know, to put the shoe kind of on the other foot, you could argue that hey, This did impact profitability, we screwed it up, it’s not going to impact profitability moving forward, because we have changed either our process or our controls. And that is why we’re forecasting even though the way we are. And it may be incongruent with what has historically been in place. And then, you know, a, a buyer can take that into consideration when they’re calculating their return rates on the investment environment.

Ryan Barnett  20:28

Yeah, makes total sense. And, Mike, will you take a look at this, again, the This is used to help understand the true profit of the firm. It begs the question of valuations and valuation methodologies. How far back does someone need to go when they’re considering some of these add backs? Yeah, that’s a good question. I think, you know, three years, that’s kind of a minimum window. I think five years is better. I think you should have an appropriate understanding of what is an addback is and what a what a discretionary? You know, what discretionary spending, and we’re doing this addbackable? I know, we’re very clear, like when we do valuations, and we’re evaluating, you know, sellers on behalf of our buyside clients to let sellers know, what is considered appropriate, right, what is the guidance around what’s in and what’s out. Because without that, you know, the natural tendency is for sellers to throw everything in the kitchen sink, in the Add backs. To try it out. No optimize EBITA but, but more importantly, they’re not thinking of it like the buyer, right? If you’re a seller, you got to walk them out in the buyers shoes and say, if I was buying this business, what would I want these guys to cut out? And what would I not have the discretionary spending side, because they’re gonna run this thing, right, I need to be able to manage it and, and be effective with this business. And if I cut all the accounting staff, and marketing staff and cut the sales team by half, and, you know, cut compensation, and eliminate bonuses, and all that stuff, that would be considered an overreach for an ad back, you wouldn’t want to run that business, you wouldn’t be able to run that business. So I think you need to be, you know, cognizant of that. Make sure that you’re looking at it, you know, through that lens of, you know, the other person’s perspective. And and, you know, three years is certainly a requirement five would be preferred. Yeah, that makes sense. And just a few more questions here. If we get a lot of questions here, so it’s one of those where, if you have any, if you’re out there, and this is something that you you’ve been wondering about, it’s worth a call with an advisor. But one of the views and questions or suggestions is that if you do have a lot of discretionary spending, and oftentimes this may sit on a credit card, be prepared to show documentation on how that was either a personal spend, or that was a discretionary spending. Just having that proof and backup will make the process easier with buyers, the buyers may push back on a discretionary spending that you have. The other thing to consider here, is it what is the view of this compared to what the IRS might think of some of these regressive discretionary spending? Are we kind of in two different worlds? Mike?

Mike Harvath  23:47

Well, I think the rules are pretty clear. From the IRS perspective on what’s allowed and what’s not. There’s certainly been a lot of things that have have gotten much more conservative from the IRS view on on what is considered an acceptable expense. So for example, a lot of entertainment expenses have been eliminated, so and applicable, quote unquote, write off from a tax perspective. Now, that’s different from what needs to be considered or what you might have done. That would be a legitimate add back. Because there it’s just a different criteria. Right. So, you know, if you spent money legitimately spent corporate funds on something that won’t continue, that was considered discretionary. You might not be able to write that off on your taxes, right, and maybe something that, you know, whether it’s appropriate or not, whether you tried to write it off, whether or not I would certainly talk to your tax accountant, what’s legal and appropriate. But if it was done what way or another, it may still be an add back. You know, it may be an add back that should occur because the litmus test really is, will this cost need to occur? Or will it occur post transaction? Whether it was considered legitimate or not from a tax perspective? Isn’t the question, it’s more? Will it occur post transaction? Or does it need to occur post transaction in order to have a going concern? And generally, if the answer is no, then it can be added back. And so just keep in mind, these are kind of two different, you know, bars or hurdle rates or bars you gotta get over, as it relates to, you know, scrutiny of the expense. And don’t confuse the two, because oftentimes we see people that have made these discretionary expenses on behalf of the business. And, you know, it is what it is right, whether or not they have been able successful, right off or not, it’s really not our concern. It’s much more about, you know, will it continue to post transaction or not?

Ryan Barnett  26:19

Yeah, that’s great. Thank you for digging in there. And kind of last question, and we’ll make it a little bit more fun. But is there been any crazy add backs that you’ve seen, or something that was just made you scratch your head of wow, that was included?

Mike Harvath  26:35

There’s plenty of those. We’ve seen really interesting things in the past, like, you know, we saw one guy who was trying to sell a business that he had actually showed a loss on the business. But he loaded it up with expenses of luxury condos, and cigarette boats, and even escort services, to the tune of about 15 grand a month on as American Express card, we can only guess what was involved with those escort services. But you know, certainly there are people that run everything through their business, whether it’s legitimate or not, and then try to kind of pull it back out. The challenge that that brings up, and I think it’s important to understand is it creates a doubt in the minds of the buyer that you are doing things legitimately legally and aboveboard, when you have all kinds of expenses run through the business, the optics of it are bad. And so I would just encourage you to, you know, run your business cleanly. And, you know, certainly some add backs are happen in every deal. But to you know, throw everything including all your living expenses, and multiple houses and boats and, and other professional services through is probably not appropriate.

Ryan Barnett  28:03

That helps, that helps. If I was to summarize this, this up here, add backs are important in an m&a transaction in looking at the valuation of your firm, if you’re selling it, they are one time expenses or perhaps better said there are non non occurring expenses in the future. So they’re not contributing to the business at any other than a one time, one time hit. So if you have a continuing expense, really, it’s not going to be an add back in buyers, but not include that in the calculation of of EBITA, you should take a look through your business and understand what the addbacks are, are included on the profit in manners as most deals are based on a transaction or a multiple of EBITA, and something like a $10,000 expense. Well, if you’re getting eight times on your business, that’s all of a sudden $80,000 You know, that’s, that’s money, that’s real money. That’s a that’s something that you can do with or you can distribute to your team. And there’s there’s a lot of reasons why you should take a very close look at your at your business. In that regard. Keep in mind that you have to, if you have a salary that may be extinguished based on redundancy, that synergy is likely going to go to the buyer. And that’s likely not going to be something that you can use as an add back though, just because you might be losing, let’s say an executive or someone in the transaction. Typically, that’s not going to be considered an add back. That may go the same with any kind of program that you continue to invest in. But it was not perhaps successful in the past. Buyers have a right to project every every addback that they look at. But sellers again really consider take it to take a deep look is it does, it comes down to, to really granted you more money at the end. So with that, I think those are the big questions that I had. Mike, I’ll let you add anything else you’d like and do what you do.

Mike Harvath  30:27

Yeah, sounds good. I think, you know, add backs are sometimes shrouded in mystery, right? What’s considered back what’s considered not an add back what’s legitimate, what’s not, I will tell you that that’s because, you know, they kind of are negotiable. I don’t want to make it sound like a Turkish bazaar here where, you know, everything is on the table. But it is a, it is a situation where you know, if you can make the case legitimately, that these costs will be borne moving forward, and that you could do you could run the business as a standalone entity without them, then there’s a pretty good likelihood you’re going to be able to get that add back. And so I think you have to sort of think through that. And again, think through that lens. I would recommend that you talk to your m&a advisor or an m&a advisor about you know, what is an appropriate add back what is defensible and what isn’t. As you begin to think about your modeling around valuation, I think credible valuation, advisors, people that do valuations like we do here, a revenue rocket, I’ve seen all this before, and certainly can advise you as a client about what is appropriate and what is not and what is likely to stand up to the scrutiny of a buyer in a situation like this. So that we’ll plan to tie ribbon eyes for this week’s podcast and in the heat of almost July in Minnesota, having a stunning run up beautiful weather here in Minnesota and I hope the same is going on for you or wherever you call. So please tune in next week, where we’ll unpack and explore more topics around m&a and growth strategy for tech enabled services companies. Thanks again for tuning in and make it a great week.