The Finance of Startups for Dummies: Add Backs in Valuation

I was speaking to a colleague recently working in private equity, and I heard about a very interesting concept called “add backs”. Add backs can play a big role in the valuation of a company. Add backs can be expenses made prior to an acquisition that are one-time and can further the growth of a company or reduce costs. These add backs can be added back to the EBITDA (earnings before interest, taxes, depreciation, and amortization).

Some examples of add backs include:

• $300,000 for laying off the bottom performing 25% sales team
• $50,000 for company jet for executive that is no longer involved in the day-to-day operations
• $1,000,000 in consulting services to deliver a strategic and execution for high growth

If a company has an EBITDA of $5,000,000 with all of the above add backs, the adjusted EBITDA (true profitability) would be $6,350,000 ($5,000,000 + $300,000 + $50,000 + $1,000,000).

In M&A transactions where multiples are applied to EBITDA, add backs can be massive. For example, if a technology company typically sells at a 7x multiple, the valuation of the EBITDA would be $35,000,000; however, its valuation on an adjusted EBITDA would be $44,450,000. That would be a difference of $9,450,000. Or simply, every $1 of add back is an additional $7 of valuation.

Sellers need to consider these one-time, transactional expenses when valuating their companies. It could be a massive missed opportunity.