What are all of these damn expenses that the broker is adding back to profits at the bottom of the P&L?

When purchasing an online business, understanding "add backs" is critical to determining its true earning potential and valuation. These adjustments refine the financial picture, especially for digital operations like e-commerce, where unique expenses can cloud profitability. This guide explores what add backs are, why they matter, how lenders—particularly Small Business Administration (SBA) lenders—view them, and how to evaluate them during the acquisition process of an online business. 

Table of Contents

1. What Are Add Backs in the Context of Online Businesses?

2. Why Are Add Backs Important in Digital Business Valuation?

3. Types of Add Backs Common in Digital Companies

4. Evaluating the Validity of Add Backs for Online Businesses

5. Documentation and Evidence Required

6. SBA Lenders' Perspective on Add Backs for Digital Companies

7. How Add Backs Affect Digital Business Valuation

8. Digital Industry-Specific Add Back Considerations

9. Due Diligence: Verifying Add Backs in Digital Companies

10. Case Study: The Impact of Add Backs on an Online Business Acquisition

11. Common Pitfalls and How to Avoid Them in Digital Business Acquisitions

12. Conclusion

What Are Add Backs in the Context of Online Businesses?

Add backs are adjustments made to a digital company's financial statements to reflect the true economic earning power of the business. They involve adding back expenses that won’t continue post-sale or are deemed non-essential, non-recurring, or discretionary. The goal is to clarify operational profitability for buyers, stripping away costs irrelevant to the business’s core e-commerce activities.

Why Are Add Backs Important in Digital Business Valuation?

When buying an online business, the purchase price is often a multiple of the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) or seller's discretionary earnings (SDE). Add backs adjust these earnings to reflect the true cash flow available to a new owner. Accurately calculating add backs ensures that you're paying a fair price based on the digital business's actual earning potential. 

I recently had a client with one line item expense for a private plane and a separate line item expense for a mountain vacation home. Obviously, neither one of these are required to generate revenue for an commerce company and were obvious add backs. All the owner had to do was provide verification that those expenses existed and were paid out of the business bank account. Not adding these considerable expenses back to the profits would've drastically reduced the perceived health of this company’s bottom line. 

Types of Add Backs Common in Online Companies

Owner's Compensation and Personal Expenses

These are expenses that benefit the current owner personally and are not necessary for the operation of the digital business.

• Salary: Owner salaries or bonuses

• Personal Travel, Meals, and Entertainment: Owner’s personal trips or dining expenses

• Health/Life Insurance: Premiums paid for the owner’s personal coverage

• Automobile Expenses: Costs for vehicles used personally, not for business logistics

• Personal Software Subscriptions: Licenses used for both personal and business purposes

One-Time or Non-Recurring Expenses

Costs that are unlikely to occur again in the future.

• Legal and Consulting Fees: One-time expenses for lawsuits, settlements, or acquisition preparation

• Major Software or System Migration Costs: Costs for shifting to new e-commerce platforms or systems

• One-Time Penalties or Fines: Regulatory or vendor fines not tied to ongoing operations

Discretionary Expenses

Expenses a new owner might opt out of:

• Office Rent: Leases unnecessary for an online business

• Personal Travel Expenses: Overlaps with owner-specific but discretionary in nature

• Charitable Donations: Owner’s personal contributions run through the business

Non-Cash Expenses

Accounting expenses that do not involve actual cash outflow.

• Depreciation and Amortization: Write-downs of digital assets or intangibles (e.g., website development)

• Stock-Based Compensation: Equity payments to employees or owners (if applicable)

• Bad Debt Write-Offs: Uncollectible customer payments

Related-Party or Unnecessary Payroll

Payments not essential to e-commerce operations:

• Family Members on Payroll: Salaries for relatives without active roles.

• Consulting Fees to Related Entities: Fees paid to owner-affiliated entities for non-essential services.

Interest, Taxes, and Other Financial Adjustments

Financial costs tied to current ownership, adjusted post-sale:

• Interest on Loans or Credit Lines: Debt costs replaced by the buyer’s financing.

Income Taxes: Adjusted based on the buyer’s tax structure.

Evaluating the Validity of Add Backs for Online Businesses

Not all add backs are created equal. It's crucial to scrutinize each one for validity, especially in the fast-paced digital industry.

• Is the Expense Truly Non-Essential for the Business?

• Will the Expense Continue Post-Sale in the Company?

• Is the Expense Non-Recurring in the Context of Online Operations?

• Does the Expense Provide a Future Benefit to the Business?

Documentation and Evidence Required

For an add back to be credible in a digital business context, it should be supported by proper documentation.

• Financial Statements

• Invoices and Receipts (including digital receipts and online payment records)

• Contracts and Agreements (including SaaS subscriptions and digital service agreements)

• Payroll Records (including records for remote workers and contractors)

SBA Lenders' Perspective on Add Backs for Digital Companies

When financing a digital business acquisition through an SBA loan, lenders have strict criteria for accepting add backs.

Criteria for Acceptable Add Backs in Digital Businesses

• Validity in the Digital Context

• Documentation (including digital proof)

• Identification on Tax Returns

Examples of Valid and Invalid Add Backs in Digital Companies

Valid Add Back Example: Scenario: The seller claims an office expense in the tax returns for business, but actually works from home, costing $2,000 per month. 

Invalid Add Back Example: Scenario: The seller spent $10,000 on a failed Google Ads campaign that didn't generate expected results. Failed marketing is never accepted as an add back.  

How Add Backs Affect Online Business Valuations

Accurate add backs increase the adjusted earnings, which can significantly impact the digital business's valuation.

Example Calculation for a SaaS Company:

• Reported EBITDA: $500,000

• Valid Add Backs: $150,000 (including one-time platform migration costs and owner's excessive compensation)

• Adjusted EBITDA: $650,000

• Valuation Multiple: 5x (common for growing SaaS businesses)

• Business Value: $3,250,000 (Adjusted EBITDA x Multiple)

Digital Industry-Specific Add Back Considerations

Different digital business models may have unique add backs to consider:

1. SaaS Companies:

   • Beta testing expenses for new features

2. E-commerce:

   • Costs associated with shifting to a new e-commerce platform

   • One-time inventory write-offs due to product pivots

3. Digital Marketing Agencies:

   • Expenses related to achieving industry certifications

   • Costs of building a company portfolio or case studies

4. Mobile App Developers:

   • App store submission fees for discontinued apps

   • One-time costs for complying with new app store policies

5. Content Creation/Media Companies:

   • Expenses related to piloting new content formats

   • One-time equipment purchases for specific projects

Of course, SBA lenders might not accept all of those add backs, but a cash buyer has more discretion when deciding what to allow.

Due Diligence: Verifying Add Backs in Digital Companies

As a buyer of a digital business, it's imperative to conduct thorough due diligence.

• Review Financial Statements and Digital Analytics Reports

• Request Documentation, Including Digital Proofs and Logs

• Consult Professionals Familiar with Digital Business Models

• Assess Necessity in the Context of Digital Operations

• Consider Future Operations and Industry Trends in the Digital Space

Case Study: The Impact of Add Backs on an Online Business Acquisition

Let's examine a scenario to illustrate the significance of add backs of an e-commerce acquisition:

Company: XYZ E-Commerce Store

Reported EBITDA: $800,000

Add Backs:

1. Owner’s above-market salary: $100,000

2. Personal use of SaaS subscriptions: $25,000

3. Legal fees for acquisition prep: $50,000

Total: $175,000

Adjusted EBITDA (SDE): $975,000

Valuation (4x multiple):

• Without Add Backs: $3,200,000

• With Add Backs: $3,900,000

Outcome: The identification and verification of these add backs increased the digital business valuation by $700,000. This significant difference highlights the importance of thorough add back analysis in the digital business acquisition process.

Common Pitfalls and How to Avoid Them in Online Business Acquisitions

1. Overlooking Recurring Digital Expenses (e.g., SaaS subscriptions, domain renewals)

2. Insufficient Documentation of Digital Transactions

3. Ignoring Tax Return Alignment for Revenue Streams

4. Misclassifying Digital Marketing Expenses as One-time Costs

Conclusion

Understanding add backs is crucial when buying an online business, as they directly influence the valuation and perceived profitability. By carefully evaluating the validity of each add back in the context of digital operations, demanding proper documentation, and considering the perspective of lenders—especially SBA lenders familiar with digital business models—you can make a well-informed purchasing decision. Conduct thorough due diligence, consult with professionals experienced in digital business acquisitions, and approach each add back critically to ensure you're acquiring a digital company at a fair and justified price.

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