Addback Magic
Big Deal Small Business: Addback Magic
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Before I dive in, a quick shoutout to Pursuant Capital’s new Search Fund Incubator, led by Sam Rosati, who was a successful searcher himself. They are focused on self-funded searchers, especially those with non-M&A backgrounds.
They’re now accepting applications for their Fall 2021 cohort, so if you’re a self-funded searcher or thinking about launching your self-funded search soon, read more and apply here.
If there’s one thing that unites the SMB acquisition community and institutional private equity folks, it’s bashing on terrible EBITDA addbacks.
I’m sure this readership community has seen it all, the good, the bad, the ugly.
Addbacks have the magical ability to turn $100K of Net Income into $1M of EBITDA.
That said, EBITDA addbacks do serve a purpose — they are meant to normalize EBITDA to represent the true earnings power of the business. Reasonable addbacks are…reasonable.
So how do we sort through the noise? I’ve racked my brain to think of the broad categories of addbacks I’ve seen over the years and listed them all below. I’ve organized them into Big Business (what I’ve seen in PE) and Small Business (what I’ve seen in search).
I gotta say — I’ve added a LOT of addbacks to this list since venturing into SMB acquisitions. Also, Big Business addbacks are often seen in Small Business deals as well (but not vice versa).
So how do we sort through addbacks?
Rather than write 15,000 words on this topic, I summarized into a table below. I’m sure I’ve missed some categories, and the creativity of brokers & CPAs will probably make this list obsolete the moment I publish it.
Before I dive in, three notes:
One: I always include a “GM” in my math — the GM is going to be me, but I will take a salary from the businesses. The EBITDA and resulting valuation should make sense for my investors, not just me, so including GM expenses is required.
Two: I didn’t include owner’s personal expense as an addback in my table. I hate this addback. It’s nearly impossible to diligence. It also indicates the owner views the business bank account and his personal bank account as interchangeable.
This creates a risk that the owner has inadvertently been paying for business expenses out of his personal accounts. Obviously that’s suboptimal for him (expenses aren’t tax deductible), but it’s plausible given there’s no mental boundary between the two accounts.
Business expenses that are not on the P&L are basically impossible to find during diligence. You’ll find out 3 months after closing that “oh wait, I guess John always put office cleaning crew’s bill on his personal Amex”.
Three: I’m happy to move expenses from EBITDA to Capex. I base my valuation work off of EBITDA minus Capex, so those expenses get captured there.
Let’s say the Seller claims their EBITDA is $750K. I do my work and decide I think EBITDA minus Capex is $670K. If I’m willing to pay 4.0x EBITDA minus Capex, that means I can pay $2,680K for the business. That translates to 3.6x the Seller’s EBITDA.
I don’t get into the dogfight of arguing addbacks — I just say I’m willing to pay 3.6x your EBITDA. If they try to argue multiple higher, then I’ll start wading into addback discussions.
This is similar to the idea “You name the price, I’ll name the terms.” If you want to name EBITDA, I’ll name the multiple.
Enough preamble, here is my non-exhaustive but exhausting-to-put-together list (you may have to click “download images” for the table to load):
Conclusion
EBITDA addbacks can seem like magic, turning paltry Net Income into juicy EBITDA. There is a method to the madness, and hopefully the above helps you parse through some of the noise.
Let me know if I’m missing any big addback categories. And of course, everyone’s favorite subject, what’s the worst addback you’ve ever seen? Hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing