Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The EBITDA Addback Trap That Cost a Seller 11 Million
Transcript
- Lucas: So there's a kind of quiet killer in M&A deals that doesn't show up in the headlines, and it's the EBITDA addback. And I've got a specific case in mind – a manufacturing company in the Midwest, about forty million in revenue, and the owner lost eleven million dollars at the closing table because of it. Luna: Eleven million – that's not a rounding error. How does that happen? Lucas: Well, the buyer's quality of earnings audit, the q of e, found that a big chunk of the addbacks the seller had claimed just didn't hold up. And the purchase agreement had a working capital peg tied to that adjusted EBITDA, so the shortfall came straight out of the seller's pocket. Luna: So the seller was essentially penalised twice – once on the headline price and then again on the working capital adjustment? Lucas: Exactly. And the painful part is that these addbacks were things many sellers would consider normal. Owner's salary above market, discretionary perks, a one-time consulting fee to fix a supply chain issue, even some legal costs from a lawsuit that was settled. On paper, they justified maybe fifteen million in addbacks. The q of e whittled that down to about four. Luna: So what makes an addback defensible versus just a hope and a prayer? Lucas: Good question. A defensible addback has three characteristics: it's truly non-recurring, it's clearly documented, and a reasonable buyer would agree it doesn't reflect the ongoing earning power of the business. The owner's personal car lease – that's usually fine. But the one-time consulting fee? That got challenged because the buyer argued it was really a recurring cost in disguise, and the seller couldn't prove it wouldn't happen again. Luna: And the owner's salary addback – that's a classic. How did that one play out? Lucas: The owner paid himself nine hundred thousand a year when a professional CEO would cost maybe four hundred. So he claimed a five-hundred-thousand-dollar addback. The buyer's q of e team came back and said, 'Fine, but you're also the founder and chief sales officer. If we have to hire a CEO and a sales leader, that's more like seven hundred thousand.' So the addback actually became negative relative to his ask. Luna: Ouch. So the seller's own pitch to justify his compensation backfired. Lucas: Right. And here's the thing – this is where an experienced M&A advisor earns their fee. A good advisor would have stress-tested each addback before the letter of intent, not after. They'd have run a mock q of e, flagged the weak ones, and either dropped them or renegotiated the peg before it was locked. Luna: But I imagine the seller wasn't eager to hear that his addbacks were too aggressive. Especially when he'd been told by a friend that addbacks were free money. Lucas: That's the trap. Sellers hear 'addback' and think it's a license to inflate. But the buyer is going to do a quality of earnings review with forensic accountants, and every addback is a potential reduction in the purchase price or a working capital clawback. In this case, the q of e took the adjusted EBITDA from, say, twelve million down to eight. That's a four million drop in the enterprise value, but then the working capital target was also set based on that inflated number, so the seller had to write a check at closing for another seven million to true up. Eleven million total. Luna: So the seller loses twice because the addbacks were baked into two different parts of the deal. Lucas: And sometimes it gets worse. If there's an earnout based on future EBITDA, those inflated addbacks come back to haunt you because the baseline for the earnout is higher. So you're not just losing on day one; you're also making it harder to hit your earnout targets. Luna: I've heard of earnout targets being sky-high for that reason. But what's the seller's protection here? Lucas: The best protection is a thorough sell-side quality of earnings before you go to market. It costs fifty to a hundred thousand dollars, but it can save millions. That report becomes the foundation for your addback schedule. And then you attach that schedule to the LOI and the purchase agreement, so the buyer's q of e is validating something you've already tested. Luna: But isn't there a risk that a sell-side q of e just becomes another marketing document? The buyer's advisors are going to pick it apart. Lucas: That's fair. But a credible sell-side q of e is done by a reputable firm with the same standards as the buy-side, and it won't be aggressive. The point is to have a defensible baseline, not to win every argument. In our case, if the seller had run his own q of e, he'd have known his addbacks were only worth four million, and he could have set the price and the working capital peg accordingly. He'd have lost maybe a million in price, not eleven. Luna: So it's about managing expectations, not just maximizing the number. Lucas: Exactly. And that’s where a good advisor really matters. They should be telling you early on, 'Look, this add-back is weak, let's not rely on it.' Instead, too often sellers have advisors who just nod along to keep the engagement. Luna: And I bet the seller in this case felt like he was being 'reasonable' by not claiming the entire owner's salary or every single perk. But he still got burned. Lucas: He did. And there's another layer – the reps and warranties. In the purchase agreement, the seller had to represent that the financial statements were accurate and that the addbacks were true and correct. When the buyer discovered the addbacks didn't hold up, they had a claim under the indemnification provisions, not just a working capital adjustment. That could have been millions more in liability, but fortunately for the seller, the buyer chose to adjust the price and the working capital rather than pursue a full-blown indemnity claim. Luna: So the buyer had leverage. They could have walked away or demanded a huge escrow holdback. Lucas: Right. And in a competitive auction process, an aggressive addback schedule can actually kill the deal entirely. I've seen buyers reduce their offer by more than the claimed addback just to send a message, or walk away when they smell something off. The seller is not in a position to argue because they've already signed an exclusivity agreement. Luna: So what's the practical advice for a seller looking at their own addbacks right now? Should they just assume every addback will be cut in half? Lucas: I'd say be conservative. If you're not comfortable defending an addback in front of a forensic accountant, don't claim it. And definitely don't put it in the draft CIM that goes out to potential buyers. Every addback you list there is a flag for the buyer's diligence team. It's better to under-promise and over-deliver – show that your EBITDA is real and sustainable, not a stack of adjustments. Luna: That makes sense. But isn't there a risk that being too conservative leaves money on the table? If you don't claim the owner's salary addback, you're giving away value. Lucas: There's a balance. You should claim the ones that are clearly legitimate – owner's salary above market, discretionary personal expenses, non-recurring legal fees that are truly one-time. But you need to have the documentation to back them up. If you can't show the invoice, the contract, the cancelled cheque, then it's not a real addback. And even then, expect the buyer to challenge. The key is to set the right expectation early so that the negotiation is about the few questionable ones, not the whole schedule. Luna: So the seller's mistake was treating the addback schedule as a wish list rather than a list of facts. Lucas: Precisely. And that's the core lesson here – it's not about what you want the business to be worth, it's about what you can prove. In this case, the seller walked away with an eleven million dollar lesson, which is a pretty expensive tuition. The good news is that other sellers can learn from it without paying the full price. Luna: So if you're a business owner thinking about selling, the takeaway is to sanity-check your addbacks with an independent advisor and a sell-side q of e before you ever send out the teaser. Lucas: Absolutely. And this is exactly the kind of conversation that, if it saves you from making that mistake, is worth a whole lot more than a coffee. And speaking of which – these episodes are ad-free, and they only stay that way because of listeners who chip in. If today's discussion helped you in any way, the smallest gesture – a coffee – makes a real difference. That's buy me a coffee dot com slash fexingo. We'll keep having these conversations either way, but your support keeps them running without a sponsor breathing down our neck. Luna: Yeah, and honestly, it's the best way to make sure we keep covering these real-world traps that most advisors won't talk about publicly. But back to the numbers – I'm curious, was there any recourse for the seller after the fact? Lucas: He tried to fight it, but he had signed a fairly standard no-survivor clause on the working capital adjustment – so once the final statement was agreed, that was it. The indemnification provisions survived, but the buyer didn't pursue them because they got their price cut through the adjustment. So legally, he had no leg to stand on. Luna: So the seller's only real protection was to have gotten it right on the front end. Lucas: That's the truth. And it's a good reminder that in M&A, the price you see at the LOI stage is not the price you take home. There are a hundred little adjustments between signing and closing, and the EBITDA addback is one of the most forgiving – because you can actually prepare for it. The worst thing you can do is treat it like a lottery ticket. Luna: Well, I hope our listeners take that to heart. Any final thought on how to know if an addback is truly defensible? Lucas: Just ask yourself: if this cost were to recur next year, would the business still generate the same cash flow? If the answer is no, it's probably not a legitimate addback. And then ask your advisor to stress-test it – if they can't defend it to you, the buyer's q of e won't accept it either. Luna: That's a solid rule of thumb. Thanks for breaking this down, Lucas. I think we've given our listeners a lot to think about before they sign that LOI. Lucas: Happy to. And if you're in the middle of a deal right now, take a hard look at your addback schedule – it could be the difference between a great exit and a painful lesson.