Blog - The Modern Financial Advisor

Understanding Addbacks and Adjustments

Written by Carla McCabe | Jul 8, 2019

The most challenging aspect of performing a business valuation often lies in properly considering how to address addbacks and adjustments. Making too many adjustments can inaccurately inflate a valuation; making too few will shortchange the seller.

When calculating a valuation, it’s important to view the business through the eyes of a potential buyer. The Truelytics platform predominantly uses the Discounted Cash Flow (DCF) methodology to emphasize exactly how a sophisticated buyer is going to determine value. We believe this approach is more accurate and more appropriate than simply applying a multiple to revenue or cash flow. Instead, the DCF model considers the non-financial attributes of a business, in tandem with historical and future performance.

To understand this method, think of how you and your clients determine what to invest in – you’re not necessarily concerned with how a stock or portfolio has performed in the past (though it’s important information to have), but rather how it is expected to perform going forward. Someone investing in (i.e., buying) a business is looking for the same – the buyer is buying future cash flows and making a decision based on how they think the business will perform in the future (based on historical data and the use of a pro forma). It’s an educated calculation of risk and stability.

The ultimate goal of the DCF model is to determine the free cash flow (or profit), i.e., EBOC, that the business will generate going forward. This requires the valuator to take a pragmatic look at the expenses as they have existed historically, as well as what they are anticipated to be going forward. As such, there are two primary areas where we must contemplate any addbacks or adjustments to the firm’s financials: owner’s compensation and one-off expenses.

Owner’s Comp

Owner’s compensation is comprised of a few components: salary for the role and responsibilities performed, benefits (health, disability, retirement, etc.), bonuses, and prerequisites (such as vehicles, club memberships, etc.). Note that K1 distributions should not be considered owner’s compensation, as this amount represents the profitability of the firm.

Should I Stay or Should I Go?

There are two standard questions to ask when considering if adjustments should be made for owner’s compensation. The first is, “Does the selling owner need to be replaced?” In most cases, the answer to this question is ‘yes’. If that owner is acting as a rainmaker, or working with clients, or running the day-to-day of the business, he or she is going to need to be replaced (and may even need to be replaced by more than one person).

When the answer to the first question is ‘yes’, the next question becomes, “Does the selling owner need to be replaced at the same compensation amount?” In most cases, the answer to this is ‘no’; the seller can usually be replaced at a lower cost.

For example, it’s not unusual for an owner to receive upward of $400k in total compensation – that’s the complete compensation package for their many responsibilities and roles within the business, in addition to that of being the founding owner. In many cases, that owner can be replaced by an advisor who is being compensated approximately $150k. Therefore, the difference between the two salaries gets added back to the cash flow as profit that flows to the bottom line (note that all perks usually get added back).

It’s important to remember, however, that even if the seller isn’t being replaced by one person – and instead is being replaced by multiple existing employees within the buying firm where they’re redistributing those responsibilities – there is usually increased compensation to those individuals. It becomes critical to always account for a “management replacement salary” when determining which compensation items can be added back. It’s also important to reflect regional salary levels when determining replacement salaries, as an advisor in New York City would certain cost more to replace than one in the middle of Iowa.

Will Work for…… Nothing??

One of the most frequent arguments we hear from a seller is “But the buyer has capacity! All of my compensation should be added back”. While it may be true that the buyer has capacity, people generally don’t work for free. Every book of business needs someone to manage the clients and there is a certain level of compensation that can be expected for this job. In fact, the buyer is probably going to have to work harder than ever to get to know and retain those clients (in addition to those he or she is already managing); and the buyer is going to expect that they are compensated for this effort.

Inevitably, this is when a seller usually maintains that there is indeed profit flowing to the bottom line (that they assume the buyer will realize). However, in an acquisition, whatever profit is left after expenses will typically be utilized to cover the acquisition debt.

Again, most buyers will personally want to realize some level of profit (i.e., compensation) from the business before the debt has been serviced (in fact, most buyers will expect an acquisition to be cash flow positive in year one or two) – so it’s important to consider compensation to the buyer as an expense when doing the financial modeling. As a guideline, a good question to pose to a seller is, “If you had to hire someone, what would it cost to replace what you do?”

Choosing the Correct Number

Determining the appropriate management replacement cost to use tends to be subjective and is often more of an art than a science. It’s not uncommon to run two or more owner comp addback scenarios for a particular business to help fine-tune the valuation and hone-in on where the proper valuation or offer amount should fall, always remembering that there will commonly be a cost to replace the selling owner(s).

One-Off Expenses

The next area to consider for adjustments is those of one-offs, or non-recurring expenses. These typically consist of bank service charges, charitable contributions, extraordinary client gifts or events, or any one-time expense in the base year you’re using for the valuation (such as moving expenses, one-time computer purchases, a fee you might pay to a recruiter, etc.). Basically, this is any business expense that a buyer wouldn’t assume to run or manage the business going forward.

Cost Synergies

The concept of expense addbacks seems pretty straight-forward until the question “What about expense synergies?” is asked. As with owner comp addbacks, this can fall into a grey area. When a buyer is going to realize cost savings in an acquisition, who should reap the benefit? Is it fair that the seller receives a higher valuation for what the buyer is bringing to the table? Probably not. Is it fair that the buyer gets maximum ROI on their investment at the sake of the seller? Also, probably not.

In these situations, it can be helpful to perform two valuations – the first with normalized expenses for the seller; the second with what the buyer will realize via synergistic expenses. Typically, the purchase price will fall somewhere between the two valuations.

It’s important to note, however, that synergies like this aren’t realized immediately. In many cases, the acquired business will continue to run as usual, with full staff and multiple office locations remaining open. The change in ownership and execution of integration (e.g., meeting the new clients, repapering, etc.) is quite an undertaking in and of itself. Many buyers don’t want to further disrupt the business, and risk client attrition, by more quickly integrating back office. It oftentimes takes two or more years to begin realizing some of the operational synergies.

Because of this, it’s common that a purchase price closer to the normalized valuation (not the synergistic valuation) is usually more appropriate.

Poof, Your Expenses Have Disappeared!

One of the standard objections we hear from a seller is, “But my buyer already pays all of the expenses I pay – 100% of the revenue is profit!”

Well…. no. It’s important to understand that there will always be a cost to running a business. There are expenses tied to clients, technology, rent, marketing, et cetera, et cetera. While the buyer may already pay an expense (like E&O, or rent, or phone service) those expenses are not going away – they’re simply being reallocated to an expanded client base. Overall, the expense per client may be lower, but the expense still exists.

Think of it this way – let’s say I manage 50 clients and my total expenses are $1,000 a month (that’s an expense of $20 per client each month). I’m going to acquire a business of 50 new clients and manage them from my existing office. My expenses are still $1,000 a month (or maybe even a bit higher because of more printing costs or postage). The cost for the new clients isn’t zero – instead, it’s $10 a month for each client. In essence, costs are being merged or shared.

Again, it becomes important to look at the valuation from the perspective of stand-alone cost to run versus that of a valuation based on the synergies that a buyer may realize. The proper purchase price will typically lie somewhere in the middle.

Increased Expenses

Keep in mind too that new expenses may arise from an acquisition, such as the rebranding of the acquired business, marketing costs, client expenses to avoid attrition, etc. Another area to explore is if the seller hasn’t been properly investing in technology or is underpaying their support staff – sometimes expenses will increase in order to maintain the stability of a business! These should also be factored into the valuation when appropriate.

Next Gen Transitions

One final consideration is that of a valuation done for an external third party 100% sale versus that of a gradual internal buy-in. We’re generally more inclined to add more back when performing a valuation under the guise of an external sale and less (or no addbacks at all) when doing a gradual internal transition. Here’s why. When an owner is gradually selling equity to their internal next gen successor, expenses typically continue as they have – an owner usually isn’t going to take less compensation just because another partner is buying into the firm.

So put yourself in the shoes of the next gen’er that is buying in – what are they buying? They’re buying into the benefit stream; the profitability of the firm that will be used for distributions. Therefore, it is inappropriate to base the valuation (or purchase price) on expenses that aren’t truly being added back to the profitability of the firm… because they’re not available for distribution.

Conclusion

While all of this may seem confusing or overwhelming, when you break it down piece-by-piece and examine the many moving parts individually, it really doesn’t need to be as complicated as one might think.

Additionally, you may have noticed that we’ve examined multiple valuation scenarios, all of which are entirely defendable, depending on how you view a business. We’ve also mentioned both valuation and purchase price. It’s important to not confuse the two. We believe that valuation is what it is – and it serves as a baseline for whatever initiative you’re considering (sale, acquisition, merger, corporate planning, etc.). In other words, valuation is the health metric that serves as the starting point when a buyer is determining purchase price.

As a general rule of thumb, our starting point for any valuation is that of an external 100% third party sale – and then to adjust accordingly for the specific situation. There will always be subjective aspects, and valuation can generally be considered more of an art than a science. But when you approach valuation logically, deliberately, and realistically, understanding addbacks and adjustments becomes more manageable and yields a more accurate valuation.

Want to learn more? Schedule some time to speak with one of our professionals.