Determining the Right Earnings Base

In the previous article, we discussed how Buyers evaluate a business beyond the numbers themselves. Team structure, customer relationships, operational systems, and owner dependency all shape how a business is viewed in a sale process. Once those qualitative factors begin to take shape, the focus shifts toward determining what the business is actually earning, which is often more nuanced than many Sellers initially expect 

At first glance, it may seem like valuation should begin with the bottom line on a tax return or profit and loss statement. In reality, Buyers spend significant time reviewing and adjusting financials before deciding what level of earnings they believe they are acquiring. The earnings shown on a tax return are often only the starting point of the discussion, particularly in privately held businesses where owners have spent years operating with tax efficiency in mind.

That dynamic creates an interesting contrast during a sale process. Most business owners work with their CPA over the years to maximize deductions and minimize taxable income wherever reasonably possible. During a transaction, the focus shifts in the opposite direction as Buyers, lenders, and advisors attempt to determine what expenses are truly necessary to operate the business moving forward and which expenses may have been discretionary, personal, one-time, or unique to the current ownership structure.

This process is commonly referred to as recasting financials. Recasting involves reviewing historical financial performance and adjusting earnings to present a clearer picture of what the business would reasonably generate under new ownership. In many cases, that includes identifying add-backs, which are expenses that may not continue after the sale or are not essential to the ongoing operation of the business.

For Sellers, add-backs are often one of the most misunderstood parts of valuation. Some owners worry that discussing discretionary expenses will reflect poorly on the business. Add-backs are an extremely common part of Lower Middle Market transactions and almost every business owner has them. Buyers expect to see them, lenders review them carefully, and part of a broker’s role is helping determine which adjustments are legitimate, supportable, and appropriate to include in the recast earnings.

In many ways, the process is almost the inverse of tax planning. A CPA is often focused on identifying expenses that can reduce taxable income, while during a sale process the goal becomes identifying expenses that may reasonably be removed to present a more accurate picture of the company’s true earning power. That does not mean inflating earnings or stretching adjustments beyond what can be supported. Buyers and lenders will scrutinize the recast closely and look for documentation to support the earnings. At the same time, Sellers are generally best served by identifying and disclosing as many legitimate add-backs as possible because each valid adjustment contributes to the earnings.

The types of add-backs can vary widely depending on the business and ownership structure. In some cases, owners run personal vehicles, travel, meals, or discretionary spending through the company. Family members may receive compensation that does not reflect an active operating role. One-time legal expenses, relocation costs, unusual repairs, or non-recurring events may also affect a particular year’s profitability. Buyers are not simply looking at whether those expenses existed historically. They are evaluating whether those costs are likely to continue after a transition takes place and whether the earnings of the business can realistically support future debt obligations and ownership expectations.

Historical trends also become increasingly important during this stage of the valuation process because Buyers rarely evaluate a single year of performance in isolation. Multiple years of financials help establish consistency, identify growth or decline, and provide context around unusual periods. Strong earnings in one year may be interpreted differently if prior years show instability or sharp fluctuations. Temporary disruptions may carry less weight if the broader trend of the business remains healthy and stable over time.

This becomes particularly important in businesses where performance may fluctuate based on project timing, seasonality, customer concentration, or broader economic conditions. Buyers are trying to understand not only what the business earned historically, but what level of earnings appears sustainable moving forward under new ownership. Part of that evaluation also involves understanding how much effort or involvement is required to maintain those earnings. A business may appear highly profitable on paper while relying heavily on one owner for sales, relationships, or operational oversight, while another business may report lower earnings despite carrying substantial discretionary expenses that distort its true cash flow. Recasting attempts to normalize those variables and present a more realistic picture of the business as it would operate after a transition.

For Sellers, this stage of the process can feel surprisingly detailed. Buyers, lenders, and advisors may ask questions about payroll entries, discretionary expenses, personal benefits, fluctuations in performance, or operational costs that initially seem insignificant. In reality, these discussions are central to how Buyers determine risk, interpret cash flow, and ultimately arrive at valuation conclusions. Before a valuation multiple is ever applied, Buyers first need confidence in the earnings themselves.

In the next article, we will build on this discussion by examining the difference between Seller’s Discretionary Earnings (SDE) and EBITDA, and why the same business may be evaluated differently depending on the type of Buyer involved.

When it comes to selling your business, there are no do-overs. Understanding how Buyers determine and evaluate earnings is an important step in preparing for a successful transaction. If you want help identifying the true earnings of your business, get in touch with the Business Seller Center.