Add-backs to EBITDA: how adjusted EBITDA is built and tested
Short answer
Adjusted EBITDA starts with earnings before interest, taxes, depreciation and amortization, then adds back items the buyer won't bear (owner perks, one-time costs) and deducts items the buyer will (a market-rate manager, market rent). The result is meant to show recurring, arm's-length earnings.
Normalization adjustments backed by documents usually survive a Quality of Earnings review. Run-rate and pro forma adjustments (what earnings 'would have been') usually don't, and SBA lenders can't rely on projections to meet coverage.
Once a business is big enough to be priced on EBITDA, the add-back schedule gets a new name, "adjustments", and usually gets longer. The same skepticism applies, with one extra category to watch: adjustments that describe the future rather than the past.
Three kinds of EBITDA adjustment
Normalization
Fixes the past to reflect recurring operations: owner perks, one-time legal costs, market rent, market manager salary. Documentable.
Run-rate
Annualizes a recent change: a new contract, a price increase. Possibly real, but partly a forecast.
Pro forma
Things that haven't happened: synergies, cost cuts, new products. The buyer's upside, not the seller's earnings.
Illustrative example, not a real business
Reported EBITDA is $1,050,000. The seller proposes adjustments to $1,410,000:
| Adjustment | Amount | Type | Rating |
|---|---|---|---|
| Reported EBITDA | $1,050,000 | ||
| Owner's above-market salary (excess over market GM) | $90,000 | Normalization | Solid |
| Litigation settlement | $60,000 | Normalization | Solid |
| Rent to owner's entity above market | $30,000 | Normalization | Shaky until new lease signed |
| Price increase in October, annualized | $110,000 | Run-rate | Shaky: check churn after increase |
| Savings from closing second warehouse | $70,000 | Pro forma | Unsupported |
| Seller's adjusted EBITDA | $1,410,000 | ||
| Solid-only adjusted EBITDA | $1,200,000 | ||
How a QoE tests adjustments
A Quality of Earnings provider reconciles financial statements, tax returns and bank data, then tests each adjustment against documents. Under SBA SOP 50 10 8.1, a required QoE must specifically address non-recurring items, above- or below-market owner compensation, related-party transactions, deferred maintenance and cash vs accrual differences, and assess customer concentration and sustainability. Expect normalization adjustments with documents to survive, run-rate adjustments to be trimmed to what recent months support, and pro forma adjustments to be removed.
Don't forget the deductions
Adjusted EBITDA should also subtract: a market salary for any owner role you'll need to fill, market rent if the seller's entity charged too little, one-time income, and costs the seller deferred (maintenance, marketing, hiring) that will come back.
Normalized EBITDA: what it means and where it goes wrong
Normalized EBITDA is EBITDA adjusted to show what the business earns in a normal year under normal, arm's-length ownership. Adjustments remove one-time items, bring owner pay and related-party rent to market rates, and correct accounting oddities. It's meant to answer: what will this business earn for its next owner?
Done honestly, normalization goes both ways. If an adjustment only ever increases earnings, it's a sales pitch.
"Normalized" sounds neutral. In practice, the person doing the normalizing decides what normal looks like. Your job is to make sure normal includes the costs you'll actually pay.
Categories of adjustment
| Category | Can increase EBITDA | Can decrease EBITDA |
|---|---|---|
| Owner compensation | Owner overpaid vs market | Owner underpaid vs market |
| Related-party transactions | Above-market rent to owner | Below-market rent to owner |
| Non-recurring items | One-time expenses | One-time income |
| Deferred costs | (rarely) | Maintenance, marketing or hiring the seller paused |
| Accounting | Cash-to-accrual corrections | Cash-to-accrual corrections |
| Personal expenses | Documented personal costs | (none) |
Costs that get normalized away
- The owner's unpaid second job (bookkeeping, repairs, sales).
- Marketing the seller stopped once the business was listed.
- Maintenance deferred in the last year or two.
- Staff positions left vacant before the sale.
- Price increases that customers haven't yet reacted to.
Each of these makes earnings look higher temporarily. When you rebuild normalized EBITDA, put them back.
Adding back depreciation: why it's standard and why it can mislead
Depreciation is added back when calculating SDE or EBITDA because it's an accounting deduction for equipment bought in earlier years, not cash spent this year. That's correct as far as it goes. But equipment wears out, so a buyer must still budget for replacing it.
Large first-year write-offs (Section 179 and bonus depreciation) can make depreciation swing wildly between years, so look at actual equipment purchases over several years, not just the depreciation line.
Depreciation is the least controversial add-back and one of the most misunderstood. Nobody argues it should stay in. The argument is about what replaces it.
Why depreciation jumps around
Under the tax rules, a business can often deduct equipment costs much faster than the equipment actually wears out, using Section 179 expensing or bonus depreciation (IRS Publication 946 explains both). So a business that bought $120,000 of equipment last year might show $120,000 of depreciation that year and very little the next. If you're looking at the low year, earnings look fine. If you add back the high year, they look great. Neither tells you what the business needs to spend.
Illustrative example, not a real business
A business shows depreciation of $8,000, $132,000 and $11,000 over three years. Actual equipment purchases were $15,000, $125,000 and $9,000: $149,000 in three years, or about $50,000 a year. Adding back depreciation and then setting aside $50,000 a year for replacement gives a much more honest picture than adding back the $132,000 year and ignoring capex.
How to handle it
- Add back depreciation and amortization in SDE or EBITDA, as normal.
- Pull actual capital spending for three to five years from the fixed asset register, invoices or cash flow statement.
- List key equipment with age and expected remaining life; get replacement quotes for anything near the end.
- Set a yearly capex reserve and subtract it when you work out what you can pay yourself and the lender.
- If the seller deferred replacements before the sale, price that in.
The DSCR calculator has a capex reserve input for exactly this reason.
Deferred maintenance and capex when buying a business
Deferred maintenance is repair and replacement work a seller has put off. It makes recent profit look better, because the spending hasn't happened, and leaves the bill for you. Spot it by comparing capital spending with depreciation over several years, inspecting equipment, vehicles and premises, and asking what's overdue. Then estimate a realistic annual capex reserve and any catch-up spending, and deduct them when you judge the earnings and what you'll pay.
A business can look more profitable in the years before a sale simply because the owner stopped replacing things.
Capex vs depreciation
Illustrative example, not a real business
Depreciation runs about $80,000 a year. Capital spending was $90,000, then $40,000, then $15,000 in the three years before sale. Earnings rose over the same period. The equipment list shows several machines past their expected life. A buyer should expect catch-up spending and plan a reserve closer to the long-run replacement cost.
How to find it
- Fixed asset register and depreciation schedule from the tax returns.
- Capex by year from the books or bank statements.
- Repair and maintenance expense trend.
- Physical inspection by someone who knows the equipment.
- Vehicle mileage, roof, HVAC, flooring, signage condition.
- Ask directly: "What would you replace in the next two years?"
What to do with it
- Deduct a capex reserve when you judge cash flow.
- Budget catch-up spending and include it in financing if possible.
- Negotiate price, pre-closing repairs, or an escrow.
For each adjustment you accept, write one line of support next to it: the invoice, payroll record or statement that proves it. If you can't write that line, the adjustment isn't ready to rely on.
Frequently asked questions
What's the difference between EBITDA and adjusted EBITDA?
EBITDA is computed from reported results. Adjusted EBITDA adds normalization adjustments for non-recurring, non-operating or owner-related items to show recurring earnings.
What is a run-rate adjustment?
An adjustment that annualizes a recent change, such as a price increase in month ten applied to the full year. It may be real, but it's a forecast, not history.
What is a pro forma adjustment?
An adjustment for something that hasn't happened yet, like cost savings a buyer could make. It's the buyer's opportunity, not the seller's earnings.
Do SBA lenders accept adjusted EBITDA?
They can make prudent, justified adjustments to cash flow, each explained in the credit memo, but may not rely on projections to meet the DSC requirement. For $3M+ deals, the QoE's adjusted earnings must be used.
Is normalized EBITDA the same as adjusted EBITDA?
They're used almost interchangeably. Some practitioners use 'normalized' for the narrower set of adjustments that reflect historical normal operations, and 'adjusted' to include run-rate or pro forma items.
What adjustments reduce EBITDA?
Below-market owner salary, below-market related-party rent, one-time income, deferred maintenance or marketing that must resume, and costs the seller absorbed personally.
Sources
- SBA SOP 50 10 8.1, Appendix 15 (QoE scope; adjusted DSC; projections not relied on)
- IRS Publication 946, How to Depreciate Property (Section 179, bonus depreciation)
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's Deal Check does not value businesses or give price opinions.