Add-backs are where a seller’s story meets your operating reality. Handle them well and you price risk accurately, protect your debt service, and keep goodwill intact. Handle them poorly and you either overpay or turn a cooperative seller defensive. This guide gives you a practical, repeatable way to verify add-backs while keeping the relationship smooth.
What “validating add-backs” actually means
Your goal isn’t to “win” every line item. It’s to separate real, transferable earnings from items that won’t survive post-close—and to do it with documentation, not opinions. The biggest traps: inflated owner-comp add-backs, “one-time” costs that repeat, and cuts to spend (marketing, maintenance) that you’ll reinstate on Day 1.
A simple 4-step process that preserves goodwill
1) Get a seller-prepared schedule—then ask for paper
Have the seller provide a line-by-line add-back schedule with short rationales. For each material item, request source docs: payroll registers for comp, invoices/GL detail for expenses, contracts for canceled services. No doc = provisional at best. This “paper-first” approach keeps the tone objective and avoids circular debates.
2) Reframe each add-back as a run-rate question
Ask: “Will this cost truly disappear under my ownership—or will I replace it?” If an owner’s $150k salary is added back but you’ll hire a GM at $100k, the valid add-back is $50k, not $150k. Same with “non-essential” family employees or slashed marketing you’ll restore to protect revenue. Price the replacement, not the removal.
3) Pattern-check the “one-time” bucket
Scan 3–5 years. If legal fees, consulting, or IT “cleanups” recur, they’re not one-time. Conversely, a true ERP migration or relocation can be legitimate. Tie the story to invoices and timing; recurring items don’t belong in Adjusted EBITDA.
4) Quantify only what moves value
Don’t burn goodwill on $3k line items. Focus on adjustments that move valuation or structure—the ones your lender will care about and your model can’t ignore. A disciplined QoE (even “lite”) helps you separate noise from material impacts.
Evidence menu: what to ask for (by add-back type)
- Owner comp & perks: Payroll registers (2–3 yrs), job duties/time map, market-comp data for the replacement role. Validate the replacement cost you’ll carry post-close.
- Family or “non-essential” staff: Org chart, responsibilities, and coverage plan. If you’ll backfill, treat as run-rate expense, not an add-back.
- One-time legal/consulting/IT: Invoices, engagement letters, and GL extracts across multiple years to spot repeats.
- Depreciation/non-cash: Tie to capex and asset age. High depreciation add-backs can mask near-term replacement needs.
- Discretionary cuts (marketing/maintenance): Monthlies showing timing of cuts and revenue/margin effects; your model should normalize spend if it protects revenue.
Keep the relationship smooth: how you present matters
- Lead with exhibits, not opinions. Show a side-by-side: seller add-backs vs. validated add-backs with citations to invoices/payroll/GL. It’s harder to argue with paper.
- Prioritize materiality. Open with the top 3–5 items and their valuation impact (e.g., “$180k EBITDA delta at 3.5× = ~$630k EV”). Sellers engage better when the “why it matters” is clear.
- Offer options, not ultimatums. If you and the seller can’t fully agree, bridge with structure (seller note, targeted earnout, escrow) rather than demanding a blunt headline cut.
Negotiating outcomes that protect both sides
When validation trims Adjusted EBITDA, you have three levers:
- Price: Tie the EBITDA delta to EV using the agreed multiple. Keep the math calm and transparent.
- Structure:
- Seller note to share ongoing performance risk and keep the seller engaged.
- Earnout on simple, auditable metrics (e.g., revenue/gross profit from named accounts) where transfer risk is the issue, not accounting.
- Escrow/holdback for specific, documentable exposures (e.g., tax, sales tax, contract gaps).
- Working capital mechanics: If add-backs were “created” by stretching AP or pulling forward AR, fix it with a TTM peg, collar, and clear true-up in the LOI—don’t argue at the finish line.
Red flags that deserve extra skepticism
- Adjusted EBITDA way above net income with thin support. Often a sign of stacked add-backs.
- “One-time” items repeating across years under new labels. Pattern = recurring.
- Owner-only savings you’ll need to replace (unpaid labor, under-market comp). Calculate the real run-rate.
- Deferred revenue treated like earned revenue. Separate billings from recognition; avoid paying for work not delivered.
- Seller resists documentation or access. Lack of transparency is a common reason deals wobble or fail—address early or be ready to walk.
LOI language you can use
- Adjusted EBITDA basis: “Purchase price is based on QoE-validated Adjusted EBITDA, which assumes (i) market-rate replacement for seller/related-party roles, (ii) exclusion of non-recurring items not supported by documentation, and (iii) normalization of discretionary spend required to sustain revenue.”
- Working capital mechanics: “WC = AR + Inventory – AP (per historical policy), TTM average peg with ±$[collar] and 60-day true-up. Deferred revenue excluded from peg; any cost-to-fulfill adjustment handled separately.”
- Risk-sharing tools: “If parties disagree on specific add-backs, consideration to be bridged via seller note/escrow/earnout tied to defined, auditable metrics.”
A quick example
Seller’s claim: $1.2M Adjusted EBITDA, including:
- $180k “excess” owner comp
- $60k “one-time” legal
- $40k marketing cuts during sale prep
- $50k family payroll
Validation:
- Replace owner with $120k GM → valid add-back = $60k, not $180k.
- Legal shows up 3 of last 4 years → disallow $60k.
- Marketing must return to maintain revenue → disallow $40k.
- Family role actually runs scheduling; you’ll backfill at $45k → valid add-back = $0.
Revised Adjusted EBITDA: $1.2M – ($120k) = $1.08M.
At 3.5×, EV delta ≈ $420k. Options: reduce price by $420k or keep headline price and shift $300k into a seller note + $120k earnout tied to 12-month gross profit retention on the top cohort. Relationship stays intact; risk is shared where it lives.
Buyer checklist
- Seller add-back schedule with docs attached (payroll, invoices, GL).
- Replacement-cost summary for owner/family roles at market comp.
- Multi-year scan for recurring “one-times.”
- Normalized spend view for marketing/maintenance that protects revenue.
- TTM working capital peg, collar, and LOI true-up language.
- Structure menu ready: note / earnout / escrow mapped to specific risks.
Validating add-backs doesn’t have to turn into a fight. Lead with documents, focus on what moves value, and give the seller choices that swap debate for structure. You’ll protect your downside, keep momentum, and still close a deal both sides feel good about. And if transparency or math won’t cooperate, you’ll know early—before deal fatigue sets in.
Contact us today or book a free consultation and learn how we can be a trusted partner on your next deal!
