An add-back is an argument

What a Quality of Earnings review does

Buyers do not price your earnings. They price their version of your earnings. Somewhere between the letter of intent and closing, the buyer commissions a Quality of Earnings (QoE) review: an accountant's review that tests whether reported and adjusted earnings are real and sustainable. The QoE firm works for the buyer. Its job is to find out whether the number in your CIM is the number the business actually earns.

A QoE review asks three questions. Does revenue tie to the cash in the bank? Are the expenses complete, or have some been left out or run through another entity? And is each adjustment to earnings defensible: would a reasonable buyer accept that this cost will not continue after the sale?

The answers matter because of how the price is built. Buyers price a multiple of adjusted EBITDA, so every dollar of defensible adjustment is worth that multiple in price. Every dollar that does not hold up costs the same multiple, and something more: it costs credibility. A buyer who finds one weak add-back starts to doubt the rest of the list.

That is why adjusted EBITDA is built, not declared. The buyer's accountants will rebuild it either way. The only choice is whether you built it first.

From net income to adjusted EBITDA

The path from the tax return to the number a buyer will accept is a bridge, built one step at a time. The playbook's illustrative version starts from net income, adds back interest, taxes, depreciation, and amortization to reach EBITDA, and then applies the adjustments that are specific to the owner and to one-time events.

Two things in the bridge deserve attention. First, every positive adjustment is a separate claim, and each one needs its own evidence. Second, two of the adjustments are negative. The business pays below-market rent on a lease from a related party, and a family member works in the business without pay. After the sale, a buyer will have to pay market rent and a market wage, so both reduce the earnings a buyer will accept.

Four kinds of add-back

Not all add-backs are equal. Some are accepted without discussion. Some are accepted with documentation. Some are negotiated. Some destroy the credibility of everything else on the list. The playbook's add-back defensibility matrix sorts them on two questions. How strong is the documentation: can you prove it with a contract, an invoice, or a payroll record? And how conventional is the adjustment: does the market routinely accept this kind of add-back?

• Bankable. Conventional and well documented: owner compensation above market with the payroll records to show it, a settled lawsuit with the invoice. These belong in adjusted EBITDA, with the file behind each one.
• Provable but unproven. Conventional, but the evidence has not been gathered: owner compensation or a one-time item with nothing on paper yet. Document these now. They are worth the multiple.
• Negotiable. Documented but debatable: a price increase that has not yet run through a full year, a product line that has been discontinued. Present these separately, as additional considerations, not inside adjusted EBITDA.
• Credibility risk. Contested by the market and weakly documented. Leave these out. One of them can sink the whole list.

Only the first group belongs in the headline adjusted EBITDA. The second can join it once the documents exist. The third is a conversation to have with a buyer, clearly labeled as one. The fourth is a liability.

Three add-backs that rarely survive

The add-backs a buyer's accountants refuse most often sit in the credibility-risk corner: contested by the market and thin on proof. Three of them come up again and again.

Savings that would have happened

The founder argues that a cost would have been lower if something had been done differently: a supplier switched sooner, a role left unfilled, a contract renegotiated. These are forecasts, not adjustments. A buyer pays for what the business earned, not for what it might have earned, and a list that mixes the two invites doubt about everything on it.

Aggressive personal expenses

Some personal expenses that run through a business are clear and easy to document: a car only the owner uses, a family phone plan. Others are a stretch: travel that was partly for business, meals with people who may or may not be customers, a share of a home office. When the line between personal and business is blurry, a QoE reviewer will usually treat the expense as a cost of the business. Claiming the blurry ones tells the reviewer to look harder at the clear ones.

Undocumented cash

Cash income or cash expenses that do not appear in the records cannot be added back, because nothing ties them to the business. A founder who says the business really earns more than the books show is telling a buyer that the books are unreliable. That is the opposite of the message an add-back list is meant to send.

Leaving these out costs less than it seems. A shorter list where every line holds is worth more than a longer one where the buyer argues with each item, because the buyer's confidence in the list carries over to the number itself.

The adjustments founders forget

Founders build add-back lists to raise their earnings. Buyers build their own lists to lower them. The negative adjustments are the ones founders forget, and a buyer will find them.

• Rent below market. If the business leases its building from the founder, or from a company the founder owns, at less than a market rent, a buyer will adjust earnings down to a market rent. After the sale, someone will have to pay it.
• Unpaid or underpaid family members. A spouse who keeps the books for nothing, or a relative paid well below the going rate for the role, is a cost the buyer will have to pay at market after closing.
• An owner paid below market. Owner compensation above market is a standard add-back. The reverse also holds: if the founder pays themselves less than it would cost to hire someone to do the job, a buyer will adjust earnings down by the difference.

Putting these on your own list first does two things. It removes a surprise from diligence, and it makes the positive adjustments more believable. A list that only goes up reads as advocacy. A list that goes both ways reads as analysis.

How to prepare the list

Preparing adjusted EBITDA is not complicated, but it takes time, and it is best finished well before a buyer is involved.

1. Start from statements that tie. Move to accrual books if you are not on them, and reconcile revenue to the bank. A QoE reviewer will start with a proof of cash, and so should you.
2. List every adjustment, both ways. Walk the income statement line by line with your CPA or CFO. Write down every cost a buyer would not incur, and every cost a buyer would have to add.
3. Sort the list. Place each item in one of the four groups above. Keep the bankable ones, document the provable ones, separate the negotiable ones, and drop the rest.
4. Build the file. For every add-back you keep, assemble the contract, invoice, or payroll record that proves it, so the evidence is ready the day a buyer asks.
5. Test it before a buyer does. Have someone who thinks like a buyer's accountant review the bridge. The add-backs that will not hold should be removed by you now, not by a buyer later.

This is the work at the center of the Go-To-Market Analysis (GTMA): a line-by-line review with your CPA or CFO that keeps only the add-backs that will withstand a Quality of Earnings review. Whether you do it with us or with someone else, do it first.

An add-back is an argument. Bring the evidence.