Imagine that you were in the market for a Harley-Davidson motorcycle. Imagine that you found someone willing to sell one to you. Imagine that that person wanted to pretend that their Harley-Davidson motorcycle was not a motorcycle but that it was, instead, a unicycle; an extremely noisy, pollution-causing unicycle. Perhaps it was this seller’s life-long dream to be a unicycle rider. Maybe he tried for many years to learn how to ride a unicycle but he was never able to do it. Then, as a result of the emotional devastation that he suffered from not being able to accomplish this goal, he began to dissociate from reality. He began to think that all motorcycles were unicycles. He then bought a Harley-Davidson, learned to ride it, and believed that he had learned to ride a unicycle.
Now the time has come for him to sell that motorcycle. He desperately needs you, the buyer, to pretend that his motorbike is a unicycle because if you do not, he will be forced to accept a tragic reality. This means that he needs to sell the motorcycle to you at a price that seems appropriate for a unicycle. This situation might seem outlandish, but it’s actually similar to the situation in which many buyers and sellers of companies find themselves because of add-backs.
Add-Backs Help You Avoid Taxes
Almost no business owner wants to pay taxes and many employ various tactics to alleviate as much of their tax burden as they can. One way in which business owners avoid taxes is by going on vacations that they would like to go on for personal reasons and claim that those vacations are business-related. Another way an owner can elude taxes is to claim that one of their family members is an employee of theirs. This will allow the business owner to pay that family member a salary, which will allow the business to pay a smaller amount in taxes. Profits are largely just an engineered number, and adding a family member to your payroll reduces your actual profits. So, when the owner’s son is brought on board to be the venture’s “Chief Engineering Evangelist,” this could be a sign.
When a business owner utilizes tax avoidance tactics like the ones mentioned above, they make their business seem to be worth less than it is actually worth. There is no real need to take “business trips” that are actually personal vacations or to pay a salary to a family member who does not actually perform any work for the company. If a company’s owner does these things then that company might actually be far richer than it appears to be on paper. If one wanted to obtain a more accurate picture of the true value of the company, she or he would need to take those types of expenses, which had previously been subtracted from a calculation of the company’s value, and add them back into that calculation. For that reason, these types of expenses are referred to as add-backs.
As the Institute For Business Acquisition states, “The best way to describe add-backs in this context (the context of business acquisitions) is: business expenses on the financial statements that will essentially ‘go away’ when the business is sold and handed over to the buyer.”
Just Move Along
Obviously, if a business owner chooses to use add-backs to avoid taxes, their decision to do so will benefit the buyer of that business if and when that business owner decides to sell the company. You might be asking yourself why all business owners who want to sell their companies don’t simply acknowledge that these “add-backs” are not expenses that their companies would need to incur after they are sold and demand a price for their company that does not take these unnecessary expenses into account. The reason that many owners do not do that is that they don’t want to, well, embarrass themselves. They want their companies to be seen as organizations that are run efficiently. They don’t want to tell people that their companies are incurring unnecessary expenses because incurring unnecessary expenses is what inefficient companies do. Therefore, they will claim that all of the expenses that they are incurring are necessary. They will say that people should just accept their claims that they really need to pay for these things and that there is no reason to suspect otherwise.
Most business owners who utilize add-backs probably have not disassociated from reality. However, if you get the opportunity to purchase a company from an owner who uses add-backs extensively, you should probably seize it because it might be the closest thing to purchasing something from someone who doesn’t know what’s real and what isn’t that you’ll ever get to experience.
Check out the Aha To Exit blog for more valuable information for anyone who wants to launch their venture or scale their business successfully.