Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / Why EBITDA Addbacks Can Inflate a Business Sale Price
Transcript
- Lucas: So Luna, we talk a lot about multiples on this show, but today I want to dig into the thing that actually determines the multiple, the number sitting underneath it, the EBITDA itself, and specifically the addbacks. Luna: Oh, the addbacks. That's where the magic happens, or the smoke and mirrors, depending on who's doing the math. Lucas: Exactly. In the last year, we covered a commercial HVAC services company, mid-sized, did about six million in revenue, and the seller was asking for eleven times EBITDA. The initial EBITDA number they presented was one point two million. Luna: And eleven times that would put the price tag at over thirteen million. Pretty rich for a regional HVAC player. Lucas: Right, but here's what was interesting. The EBITDA they were quoting wasn't the EBITDA from their tax returns. It was what they called 'adjusted EBITDA', and that adjustment was a laundry list of addbacks. Luna: Addbacks, for anyone listening who's not deep in M&A, are expenses that a seller argues a new owner wouldn't have to pay. So they add them back to net income to inflate the cash flow the buyer is actually buying. Lucas: Right, and they can be legitimate. The owner's salary above what you'd pay a professional manager is a classic one. One-time legal fees from a lawsuit that's long settled. The cost of a new roof that won't need replacing for twenty years. Those are real. Luna: But the HVAC guy's list he had his brother-in-law on payroll for forty grand a year, a truck that was clearly for personal use, and three family trips billed as 'customer entertainment'. Lucas: Yeah, and each of those is a yellow flag on its own, but together they hint at a business where the owner's lifestyle is pretty well woven into the expenses. The buyer's due diligence team, they didn't just take the list at face value. They asked for receipts, credit card statements, and the actual employment records for that brother-in-law. Luna: What did they find? Lucas: So the brother-in-law, he was a part-time 'operations consultant' who logged about six hours a week. Forty grand for six hours a week is a nice gig if you can get it. The trips, they found one was to a golf resort in Florida, and the 'customer' they were entertaining, there was no record of that customer ever doing business with the company. Luna: Ouch. So how much did they end up slicing off the addbacks? Lucas: Four hundred thousand dollars. Of the one point two million in adjusted EBITDA, four hundred thousand was either unsupported or clearly personal. That brought the real EBITDA down to eight hundred thousand. Luna: That's a thirty-three percent haircut. And since the deal was priced on a multiple, that's not just four hundred grand off the price, that's eleven times four hundred grand, which is four point four million dollars off the asking price. Lucas: Exactly. The seller was asking for thirteen million, and the final deal closed at just under seven million. And honestly, the buyer was still paying a fair multiple, but for the real cash flow, not the aspirational cash flow. Luna: So for a seller listening, what's the takeaway? I mean, you want to maximize your sale price, so you're tempted to push the envelope on addbacks. But this case shows it can backfire spectacularly. Lucas: Yeah. And it's not just that you don't get the inflated price, you lose credibility. Once the buyer's team finds a few unsupported addbacks, they start questioning every number on the income statement. They might even discount the whole multiple because they don't trust the seller's story. Luna: And in that deal, the multiple did come down, right? It went from eleven to around eight and a half, if I remember correctly. Lucas: It did. And that's the double whammy. The EBITDA shrinks, and the multiple shrinks, and the sale price takes it on the chin from both sides. Luna: So what's the smart way to approach addbacks if you're a seller who wants to get a fair price without getting burned at the negotiating table? Lucas: Well, the best advice I've heard from brokers who do this well is, be conservative. Only claim addbacks you can defend with a paper trail and a clear explanation. If you're the owner and you take a salary of two hundred grand, but a professional manager would cost a hundred and fifty, you can add back fifty. But if you take a salary of two hundred and also pay your spouse a hundred for 'consulting', and they never show up to the office, that's going to get cut. Luna: And if you know you're going to sell in a few years, you should be cleaning up those expenses now, not in the middle of a deal. Lucas: Exactly. The sellers who get the best outcomes are the ones who, two or three years before they even list, start running the business as if they're already being audited. They take reasonable salaries, they separate personal expenses completely, and they document everything. Luna: It's like they're training for a marathon, not sprinting at the last minute. Lucas: Yeah, and it pays off because when the buyer's due diligence comes in, the addbacks are boring. There's nothing exciting, but there's nothing scary either. And that builds confidence, which often translates into a higher multiple or at least a smoother process. Luna: And on the buyer's side, this story is a reminder that you can't just accept the seller's adjusted EBITDA at face value. You need to peel back the layers. Lucas: Right, and we're not talking about being adversarial. It's about being thorough. A small family business, the owners have been paying for things out of the company account for years, sometimes without even thinking about it. The buyer's job is to figure out what the true ongoing cash flow looks like for them, not what the seller's lifestyle was. Luna: And that's where a good broker or a good M&A advisor on the buyer's side earns their keep. They've seen hundreds of these lists, and they know the common patterns. Lucas: Absolutely. They'll look at the industry norms, the size of the business, and the owner's role, and they'll flag anything that seems off. And sometimes they'll push back on an addback that's technically legitimate, but just doesn't make sense for the buyer. Luna: Like what? Lucas: Like, one-time costs that are actually going to recur. Say the seller spent a hundred thousand on a new customer relationship management system. That's a legitimate addback because it's not an ongoing expense. But if the company has never had a CRM system, and the buyer is going to need to spend another hundred thousand on training and integration, well, that's not a one-time cost, that's an ongoing investment. Luna: Right, so the addback might be technically fine, but the buyer's reality is different. Lucas: Exactly. And that's why the negotiation over addbacks is often the most contentious part of a small deal. It's not just about past expenses, it's about what the future owner is actually going to have to spend. Luna: So, if you're a seller, how do you protect yourself from being on the wrong side of that negotiation? Lucas: First, get your financials in order before you go to market. That means clean books, no commingled funds, and a clear accounting of any owner perks that you're going to claim as addbacks. Second, work with an advisor who's going to be honest with you about what's defensible and what's not. Sometimes you need to hear that your 'creative addbacks' are going to hurt you more than they help. Luna: And third, maybe think about the story you're telling. If a buyer hears a list of addbacks that all say 'this business is actually more profitable than it looks', they're going to be suspicious. But if you present a clean, conservative picture, they might be more willing to pay a premium for the quality of the earnings. Lucas: That's a really good point. And it's something we've seen time and time again on this show. The businesses that sell at the top of their multiple range are usually the ones with the clearest financials and the least amount of drama in the due diligence process. Luna: It's like the difference between a used car that's been detailed and has all its service records versus one that's been sitting in a field with a 'ran when parked' sign. Lucas: Ha, that's a perfect analogy. And speaking of keeping things running, I want to take a quick moment here, if you don't mind, because this is something we feel pretty strongly about. We keep this show free and independent, no ads, no sponsors, no one telling us what to cover. That's a choice we've made from day one, and it's a choice we think serves you, the listener, better. If these conversations have moved your work forward, or you've picked up a tip that's saved you time or money, and you want to support that, you can do that at buy me a coffee dot com slash fexingo. It's a small way to keep the lights on here. Luna: Yeah, and we genuinely appreciate every single person who's ever bought us a coffee. It lets us keep doing what we do, without worrying about ad reads or sponsor pressure. Lucas: Alright, back to the numbers. So the HVAC deal, it closed at just under seven million, which was a fair price for the real cash flow. But the interesting thing is, the seller could have done better by being more conservative from the start. Luna: How so? Lucas: If they had presented an eight hundred thousand EBITDA from the beginning, with a few solid addbacks that they could prove, the buyer might have been willing to pay nine or ten times that, which would have been eight point five million. Instead, they asked for a fantasy number, lost all credibility, and ended up with a lower multiple on the real number. Luna: So the lesson is, in M&A, trust is the currency that matters most. Lucas: It really is. And I think that's the takeaway for today. When you're selling, your addbacks are a story you're telling about your business. Make sure it's a true story, because the buyer is going to fact-check it. Luna: And for buyers, always dig deeper than the summary. The addbacks are where the real picture is.