Add-backs are particular business expenses that are added back to a company’s profit so as to fairly determine its true profitability.
One major legitimate way a lot of businesses minimise their tax burden is by presenting certain items as expenses on their financial statements. This practise however does not present the true profitability of a business and its valuation thereof when selling it. To determine actual profitability (especially when required for a business sale), financial statements need to be adjusted by adding them back to net income. Such adjustments are called add-backs, and can include items like:
- Owner’s compensation and benefits
- Extraordinary or one-time expenses items
Add-backs are closely examined by the buyer given their inclusion in the profitability of the business to determine its valuation and price at sale.
Amortisation is the accounting and schedule of specific payments over a particular period of time. The meaning and application of this term is two-fold: in one, it refers to a schedule of fixed repayment (instalment) of the principal and interest of a loan over a given period of time; and in the other, it refers to the accounting practice of decreasing the value of assets to account for their declining worth over time. It is a non-cash expense that reduces a company’s tax burden.
Take for example a company that spent £100,000 on a patent that is set to expire in 10 years’ time: it amortises this expense by deducting £10,000 each year from its taxable income over the course of the 10 years.
In accounting, amortisation has the same meaning as depreciation; however, in practice, depreciation applies to tangible assets such as buildings, machinery and other equipment, whilst amortisation applies to intangible assets, such as patents, goodwill and brand equity.
Amortisation is important in a business sale because it is taken into account when using EBITDA (Earnings before interest, tax, depreciation and amortisation) in the multiplier method to determine the profitability and valuation of the business.
Completion Day is when all legal documentation is completed and funds are paid by the buyer to the seller. The ‘Day’ part may be misleading as it has been known for completion to take place over several days as negotiations will still be going on right up to the point of signing all the paperwork.
Different kinds of deal structures that a potential buyer will offer the seller are known as the ‘Consideration’.
When selling your business, to aid due diligence, a data room will be prepared which will contain all your available company documentation covering all aspects of the business in electronic format to provide your buyer with peace of mind as to what they are purchasing.
Deal fever is when irrational thoughts start to happen, decisions are made because your emotions get caught up, and greed makes an appearance. You start to be carried away by the big numbers being talked about, and you start to believe that your company is worth more or that the potential buyer definitely wants to buy your business. In your head, you have already started to spend the money that you actually don’t have.
A debenture is an unsecured bond; it requires no collateral in the form of a physical asset (such as a building). A debenture’s only security is the creditworthiness and reputation of the issuer (the borrower).
A disclosure letter is a document consisting of warranties, indemnities and disclosures that a business seller gives the buyer about the business when selling it. eg. Disclosing that there may be an outstanding tax or software licensing item.
This documentation, having been prepared, signed and given by the seller, and accepted by the buyer at the time of the deal, allows either party to reference it in any post deal dispute.
When buyers and sellers cannot agree on the selling price or to make sure that the buyer is committed after the sale is completed, a buyer will often suggest that a fraction of the selling price be deferred and be dependent upon the future performance of the company. This is what an earn out is.
Sales of businesses with an earnout are not an uncommon practice. There is little downside for the buyer in such a transaction:
- The immediate payment to the sellers is minimised
- Both the buyer and the seller benefit if the company does well
- The buyer pays less if the acquired company does not meet plan
- The seller is handcuffed to the acquiring company until the earnout has expired
There are disadvantages to the sellers:
- As some of the purchase price is deferred the seller may never be in a position to earn it
- After completion, the seller may not be able to influence conditions to achieve the future earn out
- Earnouts could invoke the wrong behaviour eg. strategic goals may not be aligned with earn out conditions
EBITDA or earnings before interest, taxes, depreciation, and amortisation, shows a company’s current operating profitability by calculating its net earnings before the deduction of interest expenses, taxes, depreciation, and amortisation. Despite not being a generally accepted accounting principle, EBITDA is widely used to assess a company’s performance with its present assets and under its current operational environment.