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When a prospective buyer is trying to establish whether he or she will purchase a particular business for sale, there are many buy business elements to take into consideration. When a prospect appears, besides the usual points dealing with location, suitability and longevity, the question of an accurate real-world business valuation should always be your primary objective. The seller will present a series of financial documents and it is, of course, in their best interests to portray the business for sale in a shining light. As such, the issue of “add backs” is likely to represent one of the thorniest problems.

In most instances, add backs are included in an effort to present the business from a real world point of view. When compiling traditional accounting reports, it’s essential to adhere to a set of very rigid standards – there may also be additional footnotes to consider, and depending on your point of view, these can be either positive or negative. When you’re thinking about buying a business, it’s crucial that you carefully scrutinize each and every add back, as they can often make a significant difference in your final valuation figure.

When conducting a process of due diligence, it can be a fairly straightforward procedure to check recorded sales and purchases against ledgers and against reconciled bank accounts. Far more often than you might think however, the current owner will strive to draw your attention to points which may be “one-time” instances, or to extra income which might not actually appear anywhere in the books at all. Of course, it’s always prudent to remain open to all suggestions, but you should nevertheless maintain a certain degree of skepticism at all times, until such point as you’re able to validate – or invalidate, their claims.

Don’t forget that for an item to be claimed as a “one off,” it must not have occurred during any of the previous years. Seller could argue that a particular expense is much larger than it should be due to a particular incident or requirement, but if you see a pattern of any kind, then the add back must be discounted.

One of the most common add backs, especially when the business can be owner operated, is to suggest the value of a manager’s salary. You need to establish that the outgoing owner was not actively involved in the operation of the business in this case and this figure is only of interest to you if you intend to assume the role of the redundant manager.

Add backs may not be asserted whenever they represent intangibles, such as the prospect of additional revenues due to a new marketing initiative that the outgoing owner has just put in place, for example. Nor should you believe an owner claim that you can reduce a certain category of expenses through renegotiation or other initiatives. After all, if the outgoing owner has not being able to do so to this point it seems reasonable to assume that an incoming “newbie” is likely to have even less ability to affect short-term change in this regard.

Be particularly wary when you are told that a business retains a lot of cash sales. You must essentially discount this notion from a strict valuation perspective, even though such a claim made, after review, may be seen as reasonable. If the owner has not entered the cash sales on the books, he or she will not have accounted for taxes correctly and it’s not fair for them to expect to receive a double benefit in this way, a net tax saving and enhanced business value.

When you have reviewed the complete list of business financials, treat each claim for add back on an individual case basis and never roll them into an inflated value. At this stage you must be particularly diligent to enable you to arrive at a real world price for this prospect.

Richard Parker is the President and founder of the Diomo Corporation – The Business Buyer Resource Center. His inspiring materials, seminars and consulting have assisted thousands of business buyers with achieving their life long dream to buy a business.

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