As adjusted EBITDA is one of the most important metrics buyers and investors will look at when calculating a valuation, we explore in this post what you should add back and what you should avoid.
The purpose of EBITDA adjustments is to give a clearer picture of the business’s profitability under normal operating conditions. Unusual activity, one-off expenses or owner-specific items get stripped out to get to an adjusted EBITDA figure which better reflects the earning power of the company.
As adjusted EBITDA is one of the most important metrics buyers and investors will look at when calculating a valuation, we explore in this post what you should add back and what you should avoid.
Common add-backs
Owner compensation is one of the most common adjustments in founder-led businesses. If the owner is paid above market rate, the excess may be added back. For example, if a founder is paid £250k but a market-rate replacement would cost £130k, the £120k difference may be a reasonable adjustment. If the owner is underpaid, the adjustment should go the other way, as the business will still need someone to perform that role after completion.
Genuine one-off costs can also be added back. Examples include legal settlements, restructuring costs, unusual severance, one-off recruitment fees, etc. The seller should be able to explain why the cost occurred, why it was unusual, and why it is not expected to repeat.
Related-party costs should be adjusted to market terms. This may include above-market rent paid to a founder-owned property company, management fees, family members on payroll at non-market rates, or other shared services. If the company benefits from below-market costs, EBITDA usually needs to be reduced.
Transaction costs related to the sale process (M&A advisory fees, legal fees for the deal, due diligence costs, etc.) are normally added back, as they are not part of ongoing operations.
Add-backs buyers may challenge
Buyers will focus closely on costs described as one-off where the activity appears to be part of normal operations. Security audits are a common example. A one-off cyber review after a specific incident may be a valid add-back. Regular audits required for customers, insurance or compliance/certifications are more likely to be treated as part of the normal cost base.
Recurring costs described as discretionary are also likely to be challenged. Marketing tools, customer support contractors, certain software subscriptions and compliance work may sometimes be presented as removable on the basis that they are not strictly fixed or could be replaced with cheaper alternatives. However, buyers will usually keep them in EBITDA.
Sellers should be careful with arguments that a cost is “inefficient” or “unnecessary.” Even if a buyer agrees the business could be run better, that does not automatically make the expense an add-back if it was incurred during normal trading.
What you definitely can’t add back
Owner salary should not be removed entirely where the owner works in the business. Someone still needs to manage the company, lead sales, oversee operations or maintain customer relationships after completion. The correct adjustment is to normalise the salary to market rate.
As mentioned above, normal operating costs should also stay in EBITDA. Accounting support, insurance, rent, hosting costs, customer service, compliance, sales activity, product maintenance and core software tools are usually part of running the business. Removing them may improve the headline number, but it will be challenged if the function is still required.
Revenue that has not been earned or collected should not be added to historical EBITDA: verbal commitments, contingent revenue, disputed invoices or hoped-for renewals. It’s easy to think that including these may give a better idea of the current position of the business if you have a lot in the pipeline. However, these factors should be presented and explained in a separate forecast or scenario analysis.
Post-acquisition cost savings (headcount reductions, supplier renegotiations, system consolidation, etc.) belong in the buyer’s model, not the seller’s adjusted EBITDA.
Deductions
Adjusted EBITDA should not only move upwards. The purpose of the exercise is to show maintainable earnings, so the same logic that supports add-backs can also require deductions.
Below-market expenses are a common example. If the founder is underpaid, rent is below market, family members work for reduced salaries, or related-party services are provided at favourable rates, EBITDA should be reduced to reflect the true cost of operating the business.
One-off earnings should also be removed where they do not reflect ongoing activity. This may include an unusual project, a one-time rebate, an exceptional settlement etc.
Deferred costs can also lead to deductions. If the business delayed important hiring, reduced marketing below a sustainable level, postponed compliance work, or delayed repairs and maintenance, current EBITDA may be overstated.
While deductions reduce the headline number, they make your bridge far more credible and build buyer confidence.
To conclude...
Adjusted EBITDA should give buyers a fair view of the company’s maintainable earnings by adding back or deducting any non-standard items. The aim is not to produce the highest possible number, but to present a figure that can be explained, supported and defended during diligence.
For sellers, preparing this work early is important. A credible adjusted EBITDA figure can support valuation and keep the process moving. An aggressive or poorly evidenced figure can have the opposite effect, creating doubt around the financial information and giving buyers a reason to push back on price.