Using add-backs to normalize EBITDA

How to improve valuation estimates by accounting for expenses that are not critical to operations.

What are add-backs?

"Add-backs" are expenses that are not directly critical to current operations and are thus added back to a company's reported earnings to estimate Normalized EBITDA, which is used to estimate business value.

Why Normalizing EBITDA is important

Most businesses have some amount of expenses that are not directly critical to operations.

Since "the market" (hypothetical prospective buyers) will remove any non-critical expenses to realize full earning potential, reported earnings are adjusted to estimate what the value of the business may be to the market. This is the process of "normalizing" earnings.

Without normalizing earnings by including add-backs, your client's business value may be underestimated.  Likewise, if add-backs are overstated this may lead to overestimates of valuation.

Add-back Examples

Examples of add -backs include:

• Profit sharing or incentive compensation plans. This may include expenses around pension plans, 401K profit sharing, deferred compensation plans, and profit sharing incentives. 
• Excess owners compensation expense above what a replacement salary would cost. Owners work hard to build income generating businesses and have every right to pay themselves well as a result! In the event they transition ownership, the business will have to pay someone to replace the owner's functional role. The difference between what the business would pay a replacement of the owner and what the owner is earning today may be considered an add-back expense in some cases. 
• Strategic and/or one time expenses not directly tied to current operations. This may include salaries, technology investments, or professional fees associated with future growth initiatives or one time projects. 
• Discretionary expenses. Any expenses that are considered at the owner's discretion and not critical to maintaining current operations. This may include charitable contributions, excess travel costs, country club fees, and culture-building type of expenses.

Request an estimate of "add-backs" from clients

It's best to work with your client or their accountant to understand if they have any of these types of expenses and consider if an appropriate adjustment is needed to normalize earnings. 

Identifying which expenses used to normalize EBITDA is a nuanced and complex task and is a difficult exercise to conduct by looking at the typical business tax return alone. 

Asking clients about what expenses are not critical to operations is the best way to capture this data.

How to input add-backs into RISR

Once you get an estimate of add-backs from the client, inputting them into RISR is straightforward.

1. Navigate to the Profit & Loss Data review screen

2. Input data to Adjustments to normalize EBITDA

Only inputs for the most recent year are added back to earnings for purposes of the valuation estimate.

Example Email