Add-Backs Are Lying to You: How Sellers Inflate Cash Flow

Ninety percent of the deals we see have inflated add-backs.

The seller's accountant built them. The broker's CIM presents them like gospel. And you're about to pay a premium for numbers that are not real.

We look at 120 to 150 deals a week. The pattern is the same every single time. This post breaks down the five add-back categories that inflate SDE and the one test that tells you whether the numbers are real.

Why Every CIM Is a Sales Document

Here's what you need to understand about the CIM sitting on your desk right now.

It is a sales document. It was not built to inform you. It was built to sell you.

The broker gets paid on commission. The seller wants maximum valuation. The CIM's job is to make the SDE number as large as possible. And add-backs are the tool they use to do it.

Think about the incentives. The seller tells the IRS one story. Low revenue. Maximum deductions. Every write-off they can find. Then they turn around and tell you the exact opposite. Suddenly the business is printing money.

Those two versions of reality cannot both be true.

Your job is to figure out which version is true before you sign an LOI based on inflated numbers.

Add-Back One: The Owner's Salary Shell Game

This is the most common inflated add-back.

The seller says they take $300,000 a year out of the business. They add that back to SDE. Sounds right on paper.

Except they also have their spouse on payroll at $80,000. And their kid at $50,000. None of those people will be there when you take over.

Your SDE just dropped by $130,000.

At a 3x multiple, that is almost $400,000 in purchase price you would have overpaid.

But it gets worse.

The owner adds back their full salary as if you will replace them for free. You will not. You need a general manager. That costs $80,000 to $120,000 depending on the market.

The real add-back is not $300,000. It is the difference between the owner's salary and the replacement cost. If the GM costs $100,000, the legitimate add-back is $200,000. Not $300,000.

That $100,000 gap, at a 3x multiple, is $300,000 in overpayment. And the broker put it in the CIM as fact.

Add-Back Two: "One-Time" Expenses That Never Stop

The CIM lists $50,000 in "one-time legal fees." They add it back.

Except last year there was $40,000 in "one-time consulting fees." And the year before? $35,000 in "one-time equipment repairs."

If it happens every year, it is not one-time. It is an operating expense.

This is the add-back that brokers actively encourage. Every business has unusual expenses in any given year. The trick is labeling a different category of recurring cost as "one-time" each year. Then adding back all of them.

Pull three years of tax returns and compare the add-back schedule to what actually shows up. If the "one-time" expenses rotate categories but never disappear, you are looking at $30,000 to $50,000 a year in real operating costs that the seller wants you to ignore.

At a 3x multiple, that is $90,000 to $150,000 in phantom purchase price.

Add-Back Three: "Personal" Expenses That Drive Revenue

The CIM adds back the owner's truck payment. Their cell phone. Their meals. Their travel. Labels it all "personal expenses run through the business."

Some of it is personal. A lot of it is not.

The truck that does job site visits is not personal. The phone the owner uses to close deals is not personal. The meals with clients. The travel to vendor conferences. The country club membership where they network for referrals.

These are customer acquisition and retention costs. Remove them and revenue drops.

The test is simple. If you stopped spending this money, would revenue stay the same? If the answer is no, it is not a personal add-back. It is a business expense disguised as one.

Add-Backs Four and Five: Depreciation Games and Below-Market Rent

Two more categories that inflate SDE without anyone questioning them.

Depreciation on assets that actually need replacing. The CIM adds back depreciation as a non-cash expense. Technically correct. But if the equipment is old and needs replacing, that changes everything. $100,000 in capital expenditure over the next two years means that add-back just masked a real future cost. You are paying a premium today for cash flow that is about to get consumed by replacement equipment.

Below-market rent from related parties. The seller owns the building. They charge the business $40,000 a year. Market rate is $75,000.

The CIM does not add anything back. No "personal" expense to flag. But when you take over, that rent goes to market rate. Your SDE just dropped by $35,000.

At a 3x multiple, that is $105,000 in purchase price the CIM never flagged.

We flag this in every deal where the seller owns the real estate. If the lease is below market, the valuation needs to reflect the true cost.

The One Test: Proof of Cash

Everything in the CIM is self-reported or broker-prepared. The only way to verify whether the add-backs are real is a proof of cash.

Pull the bank statements. Pull the tax returns.

Take reported revenue from the tax return and compare it to the deposits in the bank account. Take reported expenses and compare them to the debits.

The tax return says $2,000,000 in revenue. The bank statements show $1,600,000 in deposits. Someone is lying.

If the return shows $800,000 in expenses and the bank shows $650,000, the difference needs explaining.

The proof of cash reconciles what the seller told the IRS with what actually moved through the bank.

This is why we include the "Review Engagement and Verified Financials" clause in every LOI. This clause requires the seller to provide CPA-verified financial statements before the deal moves past diligence. Not the broker's recast. Not the seller's QuickBooks export. A CPA-reviewed engagement where an independent accountant has verified the numbers.

If the seller refuses this clause, that tells you everything you need to know. Sellers with clean books have no problem with verification. Sellers with inflated add-backs fight it with everything they have.

What to Do Before You Sign Anything

Ninety percent of deals have inflated add-backs. Now you know the five categories and the one test.

Before you negotiate a purchase price. Before you sign an LOI. Before you agree to a multiple based on the broker's SDE number. Do three things.

One. Pull three years of tax returns. Compare every add-back to what shows up on the returns.

Two. Run a proof of cash against the bank statements.

Three. Require CPA-verified financials in your LOI.

If the numbers hold up, you have a real deal. If they do not, you just saved yourself hundreds of thousands of dollars.

This is exactly the kind of thing that kills deals when you don't have the right team around you.

Learn more about how Regalis Capital can help you buy a business