Uncovering Hidden Value That Others Overlook

1. Focus: A Q of E analysis concentrates on determining the recurring, normalized EBITDA, a type of quasi-cash flow measure of the business, which is critical component of valuation. It looks at adjustments to EBITDA, working capital, capital expenditures, and identification of debt-like items. In contrast, a CPA audit focuses on expressing an opinion on the fairness of the overall financial statements based on materiality.
2. Timeframe: A Q of E analysis looks at current and future operating performance of the business, while a CPA audit is historical and backward-looking.
3. Materiality: A CPA audit will pass on certain immaterial items that do not affect the overall fairness of the financial statements, but these same items could have a significant impact on the valuation determined by a Q of E analysis.

The key impact on the due diligence process is that the Q of E analysis provides much deeper and more relevant insights for the buyer to assess the true, recurring core earnings of the business to determine a more informed valuation. After all, the Buyer is really buying future earnings and cash flows.

The Q of E allows the buyer to identify potential red flags, overstatements, and other issues that may not be evident from an audit alone. This enables the buyer to make a more accurate assessment of the business and negotiate the appropriate purchase price.

Here are some key questions and answers a CEO, Board Member, of a Buyer or even a Seller should consider when discussing add-backs to EBITDA with a Mergers & Acquisitions (M&A) specialist:

Add-backs are adjustments made to EBITDA to reflect a company’s “true” recurring core earnings potential. Adjustments typically include non-recurring, extraordinary, unusual, or personal discretionary expenses that the new owner will not incur going forward.

Removing those type of expenses provides a more accurate picture of the company’s ongoing operational profitability after the acquisition. Add-backs are critical because they directly impact the valuation, the multiple, and the ultimate purchase price. Buyers need to carefully evaluate these adjustments to ensure they reflect legitimate, non-core, one-time or one-off costs, and non-recurring expenses.

Legitimate add-backs must be:

• Clearly documented with supporting evidence (e.g., invoices, contracts,  payroll records, etc.).
• Non-recurring and unlikely to happen in the future (e.g., a one-time legal settlement).
• Unrelated to the actual core operations of the business.

Aggressive or inappropriate add-backs often lack clear justification or documentary support, are extremely subjective, or recur regularly as part of the Company’s normal operations. Examples might include overly optimistic cost-saving projections or speculative future revenue increases, or bad debts, which do not happen often but that still occur each year.

Common legitimate add-backs include:

• One-time legal or consulting fees (e.g., a one-off lawsuit, fees or other costs related to an M&A transaction or to a system implementation).
• Severance costs for terminated employees that seldom if ever occur.
• Natural disaster-related expenses.
• Owner-related discretionary expenses (e.g., personal travel, excessive salaries, or wages paid to non-working family members).
• Non-operating expenses (e.g., investment losses, which are unrelated to the core business).

• Lack of Documentation: Claims without clear records or receipts.
• Recurring Expenses Disguised as One-Time:  Expenses like annual marketing campaigns presented as “non-recurring.”
• Overly Optimistic Projections: Add-backs tied to speculative synergies or future savings.
• Double Counting: Adjustments already captured elsewhere in the financials.
• Broad Categories: Add-backs that lump various expenses together without sufficient detail.

Excessive or unjustified add-backs will inflate the adjusted EBITDA, leading to higher than appropriate seller expectations of valuation. If discovered during due diligence, this can erode trust, prolong negotiations, or result in deal termination. Buyers may also request additional representations and warranties or simply lower the purchase price.

A third party performed Quality of Earnings assessment (e.g., by a forensic CPA or other due diligence professional) provides an independent assessment without emotional attachment to the add-backs. This ensures the professional objectively assesses, appropriately categorizes, and values, and adjustments adequate documentation supports them. It reduces the risk of inflated EBITDA and valuations.

Industries have characteristics that oftentimes dictate what is “non-recurring or recurring because they are unique to that industry.” For example:

• Pharmaceutical firms typically incur substantial recurring R&D expenses. Those type of expenditures would be recurring, rather than one time. In fact, deferral of such recurring costs might warrant a normalizing, pro forma adjustment to include those costs, thereby lowering EBITDA and the related valuation.
• Some technology firms are oftentimes subject to recurring inventory obsolescence write-downs. Our firm has seen instances in which a company has understate those costs. Adjusting for those type of recurring expenses to increase EBITDA has inappropriately increased the related valuation. Understanding the industry and the specific business is key to distinguishing legitimate adjustments from aggressive ones.

Maybe. That’s typically done via agreement on the adjustments presented in either a sell-side or buy-side Q of E, which drives the valuation and ultimate purchase price. Including a clear framework for acceptable add-backs whether in the LOI or specified via the Q of E reduces ambiguity and potential disputes. This ensures the buyer and seller align on the treatment of specific adjustments and their impact on valuation prior to executing the transaction.

Add-backs directly impact the adjusted or normalized EBITDA, which again influences valuation. Certain adjustments may be speculative or not clearly supportive. Those may only play out in post-transaction operations. In that case, those type of items may drive earnout thresholds, or contingent valuation. I would point out that earnouts and working capital adjustments are the two areas subject to the largest number of post-acquisition closing disputes.