What is an add back?
As you may know from talking to a dental practice broker or this article on SDE, an “add back” is a defensible, discretionary business expense that isn’t necessary for running a dental or medical practice day-to-day. For example, dental exam tools and the cost of rent are necessary for running a dental clinic. If those expenses don’t get paid, the business cannot function. However, traveling to Hawaii for continuing education or paying an intern who also happens to be a nephew is not critical to running the business.
What is the significance of add-backs?
Ultimately, if a seller can add back discretionary and one-time expenses, they can increase their net income, which increases their valuation and, therefore, the amount they can earn when they sell their practice.
If you’re selling a dental practice, you can think about add-backs this way:
REVENUE – EXPENSES (NECESSARY & DISCRETIONARY) = NET INCOME
NET INCOME + DISCRETIONARY EXPENSES = A HIGHER NET INCOME
NET INCOME * X = VALUATION
Doctor’s compensation is one add-back (when calculating SDE) but what are other common add-backs?
Other add-backs we’ve seen include:
- Travel – personal and professional
- Certain professional dues
- Cars and/or leases
- Season tickets to sporting events
- Marketing expenses, like referral gifts
- Retirement plan contributions
- Dinners
- Paying parents or family members so those family members can be on the practice’s health insurance
- Entertainment for staff, like a Christmas party
- Consulting fees
- Health insurance (including the doctor’s)
Add-backs also include one-time expenses like:
- Legal fees, maybe a litigation matter from the previous year that likely won’t happen again
- Significant investments in technology, like all new computers
Uses of add-backs
Addbacks are relevant when selling a dental practice or a medical practice because they impact the reported net income of the practice. Health care and dental practice brokers often try to add back as many discretionary expenses as possible on behalf of their clients to increase their net income. The add-backs they can include will increase the net income (or not), and therefore, the valuation.
Add-backs help a buyer look at a business and compare apples to apples. For example, a buyer can look at two practices for sale that are in the same specialty, making the same revenue, and treating the same type of patient but one practice may have many loans and the other business has none. The seller who is not paying back dental school loans shows a greater net income on his or her balance sheet than the seller who is paying back school loans.
But, when dental practice brokers add the loan payments back to net income to normalize the unique situation of the sellers, the buyer can compare the two practices more equally. The buyer will bring in their dental school payment (or not) and can use the normalized net income to determine what their payments and balance sheets might look like.
Why it’s worth cleaning up your books
If discretionary expenses are going to be added back, why NOT run personal expenses through your business when you’re preparing for a transition? Ultimately, add-back expenses are subjective. It’s the onus of the seller to prove them. Although we will work to add back every defensible expense for our clients, buyers can object to, or push back, on add-backs. Because they are discretionary, it’s best to not roll the dice with trips and cars that could lower your income when you’re preparing to sell.
Add-backs can make the business look like a see-saw. If there’s a nice family trip to the Bahamas on the books in one year, the up-and-down appearance of net income can cause buyer hesitation that wasn’t there otherwise.
The bottom line: Add backs are discretionary and can be pushed back upon. If you’re selling a dental practice or a medical practice, minimize discretionary spending in your business’ last years so you will be able to demonstrate the accuracy and stability of the practice’s net income giving buyers confidence.
