Add-backs: which ones hold up when you buy a business
Short answer
Add-backs are expenses added back to a business's profit because the new owner supposedly won't have them: the owner's salary and perks, interest, depreciation, and one-time costs. They turn net profit into seller's discretionary earnings (SDE) or adjusted EBITDA.
An add-back holds up only if a document proves the cost was paid and a reason shows it won't continue. Rate each one solid, shaky or unsupported, and base your thinking on the solid ones.
Every small business sale has an add-back schedule, sometimes called a recast. It's the seller's case for why the business earns more than the tax return shows. Some of that case is legitimate: owners really do run personal costs through their companies, and they really do pay themselves in ways a new owner might not. The trouble is that add-backs are prepared by the seller or the seller's broker, who are paid more when the number is higher. Your job is to check each line.
The three kinds of add-backs
Structural
Owner salary and benefits, interest, depreciation and amortization. Nearly every deal has them, and they're usually easy to document from payroll and the return.
Discretionary
Personal costs the owner put through the business: vehicles, phones, travel, meals, family on payroll. Legitimate if proven, but proof is often thin.
Non-recurring
"One-time" costs. The most abused category, because almost every year has something unusual in it.
Solid, shaky or unsupported
A simple rating system keeps you honest. It's the one OKtoBuy's readout uses, and it works just as well on a notepad.
| Rating | Test | What to do |
|---|---|---|
| Solid | A document shows the amount was paid, and there's a clear reason it stops after closing. | Include it. |
| Shaky | Plausible, but evidence is partial, or part of the cost may continue. | Ask for specific evidence. Leave it out of your base case until you get it. |
| Unsupported | No document, or the income/cost isn't in the books at all. | Exclude it, and treat it as information about how the seller thinks. |
The add-backs that most often fall apart
"One-time" expenses that happen every year
A $14,000 roof repair is one-time. A $14,000 roof repair, then an $11,000 HVAC replacement, then a $16,000 parking lot repave is the cost of owning a building. Lay three years of repairs side by side before accepting any of them. More in non-recurring expense add-backs.
Family members on payroll
The seller says his son is paid $40,000 but doesn't work there. Sometimes true. Often the son does the bookkeeping on Sunday nights or covers the counter on Saturdays. Ask what each family member does, look at timesheets, and ask staff. If the work is real, someone will have to be paid to do it.
Owner perks with no paper trail
Vehicles, phones, meals and travel are believable add-backs when card statements and receipts show personal use. Without them, they're estimates. A vehicle add-back also needs a story: does the business need a vehicle at all? If yes, part of the cost continues.
Replacing the owner's free labour
SDE includes one owner's pay, and assumes you'll do the owner's job. If the seller works 70 hours a week doing two jobs (manager and lead technician, say), you'll be paying for one of them. That's not technically an add-back error, but it's a gap between the seller's SDE and yours.
Rent from a building the seller owns
If the seller owns the building and charges the business below-market rent, the business looks more profitable than it will be under a market lease. Adjust rent to what you'll actually pay. See related-party rent.
Cash that never hit the books
Not an add-back at all, though it's sometimes presented as one. If income wasn't reported, it isn't verifiable, and lenders won't count it. Exclude it.
Evidence to request for each add-back
| Add-back | Evidence that makes it solid |
|---|---|
| Owner salary, payroll taxes | W-2s, payroll registers, payroll tax filings |
| Owner health insurance, retirement | Premium invoices, plan statements, payroll deduction reports |
| Interest | Loan statements; confirmation the debt is paid off at closing |
| Depreciation and amortization | Depreciation schedule (Form 4562), fixed asset list |
| Personal vehicle | Lease or loan, mileage logs, who drives it |
| Personal travel, meals | Card statements with dates and places, calendars |
| Family payroll | Payroll records, job descriptions, interviews with staff |
| One-time legal, repairs, moves | Invoices plus three years of history in the same category |
| Above-market owner salary | What a market-rate manager would cost; who will do the job |
A long list of examples, each rated, is in add-backs examples.
Why lenders cut add-backs
SBA SOP 50 10 8.1 lets lenders adjust cash flow for things like seller discretionary expenses and owner compensation, but requires the lender to explain why each adjustment is prudent and necessary and how it's supported by the ongoing operations of the business. Adjustments without that support are ineligible for the coverage test. For purchases of $3 million and up, the lender-ordered Quality of Earnings report must identify and document every add-back. In plain terms: the burden of proof is on the add-back, and you should apply the same standard before your money is at risk.
What to do with the result
Once you've rated everything, you have two numbers: the seller's SDE and the supported SDE. If they're close, good. If they're far apart, you have three options: get the evidence that moves shaky items to solid, negotiate a price based on the supported figure, or structure the gap so the seller only gets paid if the earnings show up (a seller note, for example; note that SBA loans prohibit seller earnouts). Run both numbers through the SDE calculator and see how much of the asking price depends on the shaky part.
How to find add-backs on a profit and loss statement
Go down the seller's P&L line by line and ask two questions of each expense: does any of this benefit the owner personally or happen only once, and will I still have this cost after I buy? Owner wages, interest, depreciation, and personal items buried in vehicles, travel, meals, insurance and 'other' are the usual add-back candidates.
Then ask for the general ledger detail behind the lines you've flagged. Add-backs live in the transactions, not the summary.
A broker's recast tells you which add-backs the seller wants you to see. Marking up the P&L yourself tells you which ones are there, including the deductions the recast left out.
An annotated P&L
Line by line
| P&L line | What may be hiding | Ask for |
|---|---|---|
| Officer / owner wages | Owner pay (add back one owner) | W-2s, payroll register |
| Wages | Family members; seller's personal staff | Payroll by person; job duties |
| Payroll taxes, benefits | Owner's share | Payroll reports, benefit invoices |
| Rent | Payments to the owner's property entity | Lease; market rent comparison |
| Auto / vehicle | Family cars | Vehicle list, mileage logs |
| Travel, meals, entertainment | Vacations, family meals | Card statements, GL detail |
| Insurance | Owner's life or disability policies | Policy schedules |
| Professional fees | Personal legal or tax work; sale costs | Invoices |
| Repairs and maintenance | "One-time" items that recur | Three-year detail |
| Other / miscellaneous | Anything | GL detail for every dollar |
| Other income | Grants, insurance payouts, asset sales | GL detail; deduct one-time items |
Then reconcile
Once you've marked up the P&L, reconcile it to the tax return for the same year and to the bank deposits. An add-back analysis on a P&L that doesn't match the return is built on sand. See tax returns vs P&L and proof of cash. For a beginner's walkthrough of every P&L line, see how to read a P&L when buying a business.
Frequently asked questions
What are common add-backs when buying a business?
Owner salary, payroll taxes and benefits; interest; depreciation and amortization; the owner's personal vehicle, phone, meals and travel run through the business; family members paid but not working; and genuinely one-time costs like a lawsuit settlement or relocation.
Are add-backs legal?
Adding back an expense in a sale analysis is normal. But if the add-back is a personal expense that was deducted on the tax return, the seller may have a tax problem, and you should think about what else in the books is unreliable.
How do lenders treat add-backs?
Under SBA SOP 50 10 8.1, lenders can make adjustments to cash flow, but each one must be justified in the credit memo, and adjustments without supporting analysis are ineligible. In practice, undocumented add-backs get removed.
How much of SDE should come from add-backs?
There's no fixed rule, but the larger the share of SDE that depends on discretionary and one-time add-backs (beyond owner pay, interest and depreciation), the more scrutiny the number needs. If those items are a big part of the earnings, the earnings are mostly the seller's opinion.
Which P&L lines usually contain add-backs?
Officer or owner wages, payroll taxes, employee benefits, interest, depreciation, auto and vehicle, travel, meals, insurance, professional fees, repairs, and 'miscellaneous' or 'other expenses'.
What is a general ledger detail report?
A list of every transaction posted to each account. It shows who was paid, when and for what, which is how you separate personal items from business costs.
Sources
- SBA SOP 50 10 8.1, Appendix 15: adjusted debt service coverage and QoE requirements
- IRS Publication 535, Business Expenses
Related guides
General information, not legal, tax, financial or investment advice. Rules and lender practices change; check the linked sources and talk to your attorney, CPA and lender about your deal. Examples with named numbers are illustrations, not real businesses. OKtoBuy does not value businesses or give price opinions.