One crucial aspect of M&A process is the consideration of add-backs, which play a significant role in determining a company’s true earnings potential.
What are Add-Backs?
Add-backs, also known as adjustments or normalization adjustments, involve identifying and including certain expenses or deductions that are not directly related to the core operations of the business. These adjustments aim to reflect the potential earnings a buyer could generate from the target company once they take over. The goal is to present a more accurate picture of the company’s financial health by eliminating non-recurring or discretionary expenses that might not persist post-acquisition.
Let’s explore typical add-backs
Owner/Management Compensation: Sometimes, owners or key executives receive compensation that might not align with market standards. Adjusting these amounts to reflect a more typical compensation can provide a clearer view of the company’s financial performance.
Non-Recurring Expenses: Expenses related to one-time events, such as legal settlements or restructuring costs, can be added back to present a more accurate ongoing operational picture.
Depreciation and Amortization: These are non-cash expenses that represent the allocation of past capital expenditures. While necessary for accounting, they don’t directly impact cash flow and can be added back.
Interest and Financing Costs: If the target company’s financial structure is expected to change after the acquisition, adjustments can be made to account for the buyer’s different financing terms.
Discretionary Expenses: Some expenses, like excessive entertainment or travel costs, might not continue under new ownership. Adjusting or excluding these can provide a clearer picture of future profitability.
Non-Core Business Activities: Income or expenses from non-core business activities can be added back to focus solely on the core operations.
Add-backs are essential in M&A transactions as they help both buyers and sellers arrive at a more accurate valuation and understanding of a company’s true financial potential. However, it’s crucial for both parties to approach add-backs transparently and supported by thorough documentation to ensure a fair and successful deal. Working with financial experts and advisors who specialize in M&A can help navigate the complexities of add-backs and contribute to a successful acquisition process.