Charitable Donations: Pay It Forward, Add it Back
What exactly are add-backs, and how can they change the value of your business when you decide to sell it?
Any great business with a well-defined mission statement and core values likely includes charitable giving as part of its business model. Not only do those charitable donations do good for the greater community, but they can also actually help increase the value of your business when it comes time to sell it.
At Raincatcher, one of the top questions we get from people interested in selling their business is “how much is my business worth?”
If you’ve been thinking about this question, you may have already come across the saying, “A business is worth what a buyer is willing to pay.”
Don't Let Internet Myths Guide Your Valuation
In fact, that statement is far from true. Leaving the “worth” of your business up to buyer sentiment is exactly the worst approach when you’re looking to determine your business value.
Instead, you should work with an experienced business brokerage team complete with accounting professionals to identify your discretionary earnings, which is your net income plus your add-backs.
That brings us to another frequently asked question. What are add-backs?
To answer that question, we turned to Kate McMahon, CVA, Raincatcher’s Financial Analyst extraordinaire.
What Are Add-Backs?
“An add-back is any expense that is non-critical to a business’s operations and will not carry over to a new buyer,” said Kate. “Add-backs are expenses that are included in the budget but do not drive revenue. They usually benefit only the business owner, but they don’t benefit the business itself or any of its employees.”
That’s where those charitable contributions come in. These are deductible expenses for the current owner (seller) but not ones that would carry over to the new owner (buyer), explains Kate.
And add-backs can make a significant difference to the bottom line when it comes time to sell your business.
Why Do Add-Backs Matter?
To showcase the importance of add-backs, Kate gives the following example.
Say your net income is $500,000 and your seller’s discretionary earnings (SDE) are set at a 2.5x multiple, which means the preliminary valuation of your business is estimated to be $1,250,000.
Now let’s say you took a family trip to Disneyland for $20,000, you leased your car through the business for $2,500, and you paid a $70,000 salary to your son who doesn’t really work for you–not considered charity for this purpose–and you used $2,000 in accounting fees to do your personal taxes. And yes, you made $5,000 in donations to an actual 501(c)3 non-profit.
That would total $99,500 in add-backs.
By calculating your add-backs, you could now potentially sell your business for $1,492,000, rather than the original estimated value of $1,250,000.
By the way, if the jaw-dropping salary paid to a non-productive family member has you raising your eyebrows, Kate says it really happens.
“Don’t worry,” she says. “At Raincatcher, we aren’t here to judge. We are just interested in building the best case for your business.”
What Are Seller’s Discretionary Earnings (SDE)?
In the example above, the seller’s discretionary earnings (SDE) were set at a 2.5 multiple, which leads us to another question, what is SDE?
The International Business Brokers Association (IBBA) defines SDE as…
"The earnings of a business prior to income taxes, depreciation, amortization, interest, non-operating income and expenses, nonrecurring income and expenses, one owner's entire compensation (including benefits and any non-business or personal expenses paid by the business)."
Calculating SDE is important as it is a way to normalize the earnings of a business so it can be fairly compared to the earnings of similar businesses on an apples-to-apples basis.
SDE is computed for a small to midsize business to show a more accurate, full picture. Since businesses report all expenses in an effort to reduce taxes, these expenses also result in deductions that will lower the business income.
Calculating the SDE gives the buyer a better understanding of the business’s true profit and provides the new owner with a method of calculating what his potential earnings could be.
But calculating an accurate SDE can’t be done without including add-back expenses.
It is important to note that when negotiating the potential purchase of a business, a buyer will carefully scrutinize each add-back. It’s not uncommon for there to be debates about some of the numbers.
One example of a contested add-back might be if the seller hires a consultant to create a new marketing plan in advance of the sale. The seller might consider that a one-time expense, while the buyer may consider this an ongoing expense that will need to be run yearly.
Or, if you sell shoes and donate a certain percentage of the profits to organizations in need, that would likely not be considered an add back.
Strongly contested add-backs can lead to a deal falling apart, even in late-stage negotiations. So every add-back must be defensible and supported by proper documentation
Types of Add-Backs
Essentially, there are two types of add-backs, “regular” add-backs and “extraordinary” (or non-recurring) add-backs.
They roughly break down as follows
Owner compensation, when the business owner’s salary is higher than the market salary rate
Owner perks such as meals and travel not related to the business
Personal or family member auto or fuel expenditures
Owner health insurance
Health club dues
Travel & entertainment
EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) expenses: any one-time expenses that are not likely to recur, such as a moving expense.
Discretionary fees are expenses that are not likely to continue under a new owner, such as an above-market salary compensation, travel and meals.
Non-operating expenses are expenses that are not required to run the business, such as vehicles.
Non-recurring expenses are add-backs that will not likely occur again in the future, such as legal expenses, one-time upgrades, and professional fees associated with preparing the business for sale.
Kate also advises watching out for negative add-backs when calculating valuation, as negative add-backs can have an adverse effect on SDE.
She cites the example of a business owner who owns the land where the business is located and charges the business a below-market rental rate. In the business valuation, the rent should be increased to reflect the cost to the new owner, who may not get the same low rate.
Similarly, if the owner is paying themself a below-market salary, the new owner will incur a cost to hire someone of the same skill and ability.
Understanding the power of add-backs also requires a healthy comprehension of SBE and EBITDA or Earnings before Interest, Taxes, Depreciation and Amortization.
Working with a trusted brokerage team that includes a certified valuation analyst with business valuation experts on staff – like Kate.
Raincatcher highly encourages you to reach out to our team to receive a Free Confidential Business Valuation.
Click for more information on Certified Business Valuations.