John Gaskell
Director at The Business Transfer Group
John is a senior member of the Blacks Brokers team with extensive experience leading successful national sales operations. He plays a central role in developing the team’s approach to client service, drawing on a deep belief that positivity, care and drive are the defining qualities of any great salesperson. John delivers comprehensive training across the organisation that instils a client-first ethos at every level.
When a business is valued for sale, the profit figure that matters is not the one that appears at the bottom of the accounts. It is the profit the business would generate under new ownership, under normal trading conditions, without the particular arrangements the current owner has put in place over the years. Getting from the reported profit to that adjusted figure is what the add-back process is about, and it is one of the most important and most frequently mishandled parts of any business sale.
Sellers who understand how add-backs work, and who prepare their adjusted profit schedule properly before going to market, are in a significantly stronger negotiating position than those who leave the adjustment process to be driven by the buyer’s advisers. The adjusted profit figure is the foundation on which the valuation multiple is applied, and a difference of even a few thousand pounds in that figure can translate into a meaningful difference in the headline price.
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What adjusted net profit means
Adjusted net profit, sometimes expressed as adjusted EBITDA, is the profit the business generates under normalised conditions, adjusted to remove the effects of owner-specific arrangements, one-off items and accounting treatments that do not reflect the ongoing trading reality of the business.
The starting point is the reported net profit from the accounts. From there, a series of adjustments are made, some of which increase the profit figure and some of which reduce it. The result is a figure that represents what a new owner could reasonably expect the business to earn, which is the basis on which the valuation multiple is applied.
The principle behind adjusted profit is straightforward. Most owner-managed businesses are run in a way that reflects the owner’s personal circumstances rather than purely commercial logic. The owner’s salary may be set at a level that minimises tax rather than at the market rate for the role they perform. Personal costs may be run through the business. One-off events may have affected the accounts in a specific year. None of these things reflect the true ongoing earnings of the business, and a buyer should not be paying a multiple of a profit figure that includes them.
Common add-backs in a business sale
Add-backs are adjustments that increase the reported profit to better reflect true maintainable earnings. They represent costs that have been run through the business that a new owner would not incur, or that would be incurred at a different level.
Owner’s salary and drawings
The most common and usually the most significant add-back in any owner-managed business sale is the owner’s remuneration. In many small businesses, the owner pays themselves a salary that is set for tax efficiency rather than to reflect the market rate for their role. Often the total remuneration, combining salary and dividends or drawings, is substantially above what a replacement manager or director would cost.
The adjustment here is to replace the owner’s total remuneration with the cost of a market-rate replacement. If the owner has been paying themselves one hundred and fifty thousand pounds in combined salary and dividends, and a replacement managing director would cost eighty thousand pounds, the add-back is seventy thousand pounds.
This adjustment only works in one direction. If the owner has been significantly underpaying themselves, the adjustment goes the other way, reducing the reported profit to reflect the true cost of running the business without the owner’s subsidised labour.
Personal expenses run through the business
Many owner-managed businesses run personal costs through the business accounts. These might include the owner’s personal vehicle costs, fuel, insurance and servicing claimed through the company, personal mobile phone contracts, home broadband or utilities where the owner works partly from home, subscriptions or memberships that are personal rather than business-related, and meals or entertainment that are personal rather than genuinely client-related.
All of these are legitimate add-backs where they can be evidenced, since they are costs a new owner would not incur. The key is documentation. A buyer’s adviser will not accept a verbal assertion that personal costs were run through the business. They will want to see the invoices or statements, understand what each item relates to and satisfy themselves that the add-back is genuine.
One-off costs
A business sale that spans three years of accounts will almost always contain some items that are genuinely one-off and do not reflect normal trading. These might include the cost of a refurbishment or capital project that has already been completed, legal costs relating to a specific dispute that has been resolved, redundancy costs following a restructuring that is now complete, or exceptional repair costs following an insured event.
One-off costs that have genuinely depressed the profit in a specific year are legitimate add-backs, since they reduce the reported profit without affecting the ongoing earnings of the business. The test is whether the cost is truly non-recurring. A business that has legal costs every year because it is routinely in dispute with customers cannot treat those costs as one-off.
Depreciation and amortisation
Where the valuation is expressed as EBITDA rather than net profit, depreciation and amortisation are added back as a matter of course, since EBITDA by definition excludes them. Depreciation is an accounting charge rather than a cash cost, and buyers typically prefer to assess the business on its cash-generative capacity before those non-cash charges are applied.
The trade-off is that capital expenditure needed to maintain the asset base is not captured in EBITDA. A business with high depreciation charges typically also has high ongoing capital expenditure requirements, and buyers will assess the required capital expenditure separately when forming their view of value.
Finance costs
Interest payments on business borrowings are added back in the move from net profit to EBITDA, since the buyer will typically have a different financing structure and the interest cost of the current owner’s debt is not relevant to the ongoing earnings of the business under new ownership.
What buyers will challenge
Understanding which add-backs will be accepted and which will be challenged is as important as knowing what to include. Buyers and their advisers are experienced in reviewing adjusted profit schedules, and they will push back on any adjustment that is not clearly evidenced or that does not represent a genuinely non-recurring cost.
Common areas of challenge include owner’s remuneration where the replacement cost assumption is not well-supported. A seller who adds back their entire salary on the basis that a new owner would work for free will not find that adjustment accepted. The relevant comparison is the market rate for the role, not zero.
Personal expenses where the business benefit is unclear or contested are also frequently challenged. An owner who has claimed significant travel and subsistence costs will need to demonstrate that those costs were business-related to a buyer who is sceptical about the proportion that was genuinely commercial.
One-off costs that recur in multiple years are another source of challenge. If a business has legal costs, repair costs or other items that appear in the accounts every year and are claimed as one-off in each year’s adjustment, a buyer will rightly question whether those are truly one-off or whether they are a structural feature of the cost base.
Adjustments that reduce profit
Not all normalisation adjustments increase the profit figure. Some adjustments reduce it, and sellers who present only the upward adjustments while ignoring the downward ones will find that buyers discover the omissions during due diligence and make their own adjustments, usually with a less favourable view of the quantum.
Common profit-reducing adjustments include the cost of replacing owner labour where the owner has been working in the business without paying themselves a market wage. If the owner is effectively working as an additional employee without drawing a salary that reflects that contribution, the true cost of running the business is higher than the accounts show, and a buyer will need to replace that labour at market rate.
Below-market rent where the owner also owns the premises is another downward adjustment. If the business pays rent to the owner at a rate that is below the open market level, the reported profit is higher than it would be if the business were paying a commercial rent. A buyer who is acquiring the business without the premises will be paying market rent from day one, and the profit figure needs to reflect that.
Similarly, if the business benefits from supplier terms, insurance rates or other arrangements that are personal to the current owner and will not transfer to a new owner, those benefits need to be stripped out of the adjusted profit.
Presenting the adjusted profit schedule
A well-presented adjusted profit schedule is one of the most important documents in a business sale information pack. It should start with the reported net profit from the accounts for each of the last three years and then set out each adjustment clearly, identifying what it is, why it is being made and what the evidence is.
The schedule should be consistent across all three years where the same adjustment applies, since inconsistency between years suggests that the adjustments are being applied selectively rather than as a genuine reflection of the business’s normalised position.
Where the adjustment varies significantly between years, the reason for the variation should be explained. A buyer who sees an owner’s salary add-back of twenty thousand pounds in year one and sixty thousand pounds in year three without explanation will form their own interpretation, which is unlikely to be more favourable than a clear explanation from the seller.
The schedule should be prepared before the business goes to market and reviewed by the seller’s accountant before it is shared with buyers. A schedule that cannot withstand scrutiny is not just unhelpful during negotiations. It damages the seller’s credibility and creates uncertainty about the reliability of the financial information more broadly.
The relationship between adjusted profit and the valuation multiple
Adjusted profit is the input to the valuation. The multiple applied to that figure produces the headline price. This means that an error in the adjusted profit figure compounds through the valuation in a way that matters.
An overstated adjusted profit leads to an inflated asking price that buyers will not support once they have done their own analysis. This typically results in a prolonged time on market, a late-stage renegotiation after due diligence or a deal that falls apart when the buyer’s financing is refused because the lender’s own assessment of the profit does not support the price agreed.
An understated adjusted profit, which is less common but does occur, results in a seller accepting less than their business is worth. This can happen where the seller has not fully thought through the add-back process, where personal costs run through the business have not been identified or where the owner’s below-market salary has not been reflected in the adjustment.
Getting the adjusted profit right, and being able to defend it clearly and with evidence, is the foundation of a credible and successful sale process.
Final thoughts
The adjusted profit and add-back process is not an attempt to inflate the reported earnings of a business. It is an attempt to present the true maintainable earnings of a business in a way that allows a buyer to assess what they are actually acquiring. Done properly, it produces a figure that both parties can work from with confidence.
Sellers who invest the time to prepare their adjusted profit schedule before going to market, who document every adjustment clearly and who have their accountant review the output before it is shared, are starting the sale process from a position of credibility and clarity. Those who leave the adjustment process to be worked out during negotiations are ceding control of one of the most important variables in the transaction.
If you are preparing to sell your business and want to understand how your adjusted profit should be presented, get in touch with Blacks Brokers for a confidential conversation about your specific situation.
Sources
UK Government, Business asset disposal relief: eligibility and rates (capital gains tax on business disposals):
https://www.gov.uk/business-asset-disposal-relief
UK Government, Capital allowances: overview (depreciation and capital expenditure in a business context):
https://www.gov.uk/guidance/capital-allowances-overview
Financial Reporting Council, FRS 102: The Financial Reporting Standard applicable in the UK and Republic of Ireland (accounting treatment of profit and loss items):
https://www.frc.org.uk/library/standards-codes-policy/accounting/uk-accounting-standards/standards-in-issue/frs-102/
UK Government, Income Tax: treatment of benefits in kind (personal expenses through a business):
https://www.gov.uk/employer-reporting-expenses-benefits
HMRC, Employment Income Manual (EIM): benefits and expenses (HMRC treatment of personal costs claimed through a business):
https://www.gov.uk/hmrc-internal-manuals/employment-income-manual
UK Government, Corporation Tax: calculating the charge (profit computation and deductible expenses):
https://www.gov.uk/guidance/corporation-tax-calculating-the-charge
