SBA Financing - Significant Add-backs to SDE

February 09, 2023

by a searcher from Boston College - Wallace E. Carroll School of Management in Newport, RI, USA

Hi, I'm currently looking at an add-on acquisition with about $200K in net income on the P&L but another roughly $175K in add-backs. I've done my diligence and believe the seller to be an honest operator - so I am fairly comfortable that these add-backs are valid.

My question is, does this amount/ratio of add-backs to SDE present significant issues with obtaining SBA financing? Aside from this potential obstacle, I think this deal is a fairly good fit for SBA financing but am unsure how much of an issue this is or isn't.

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Reply by a professional
from University of Southern California in North Palm Beach, FL, USA

Thanks, ^redacted‌ - Here's an excerpt from one of my pubs:

Make the kind of adjustments to income and expense that (legitimate) appraisers make.

Add back to net profit the excessive amount of owner’s compensation. If interest expense or income won’t continue after you buy the company, you might want to adjust the historical net profit. If you ignore depreciation, you better have cash available later to fund the replacement of assets. Ignoring depreciation also means you’ll pay more than a company is worth; it’s because of the inflated net profit upon which valuation models apply.

Be sure you understand the implications of adjusting the income statement versus the cash flow statement. Errors here mean a dumb deal.

Don’t let sellers reclassify perks as profit. As the owner of a business, you will have all the attendant headaches and risks. You deserve usual and customary perquisites, in addition to being paid the market rate to manage the business. Seller’s discretionary cash flow should not include reasonable perks such as, health insurance, automobile and other expense allowances.

Don’t believe “discretionary” cash flow can pay debt. Don’t think “discretionary” cash flow is available to finance debt. Is owner’s salary discretionary? Is health insurance? Is depreciation? Absolutely not. Treating these as though they are discretionary expenses is a big mistake. Doing so means you earn less than the business would spend to compensate a manager. It could cause the business to become insolvent and lead to a fraudulent conveyance, which puts your personal assets at greater risk. Use the business’ net profit—after fair owner comp—to retire debt.

Reply by a lender
from Eastern Illinois University in 900 E Diehl Rd, Naperville, IL 60563, USA

I agree with Ron. It depends are what the add-backs are. In general I usually tell people if it is something that can be verified as a one-time expense or something that is a true and verifiable seller expense, it should not be an issue adding it back. However, if it is something that cannot really be verified to be one time, it will be hard to add-back. To add onto Ron's response, add-backs are seller salary, charitable donations, seller health and life insurance, seller auto (if the payments can be verified on a lease), owner retirement benefits, one-time expenses that can be verified to be one-time, family member salaries that will not continue in the business, etc. Stuff that usually cannot be added back is travel and meals & entertainment (because it is impossible to verify these are not essential for business marketing), personal expenses buried in cost of goods sold, office supplies or other expense categories (again, almost impossible to verify they are not legitimate business expenses), bonuses for staff or other expenses that are recurring but may be deemed to be discretionary (there is usually an expectation the buyer would need to continue to pay for these services or provide these bonuses to keep employees), etc. If you want someone to review the deal and provide you feedback on what type of debt can be supported, we would be more than happy to do so. We do not charge anything to review a deal and provide feedback. You can reach me here or directly at redacted Thank you.

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