EBITDA Add-Backs: What's Legitimate vs. What's a Red Flag for Buyers

The Era of "Creative Accounting" Is Over

If you are taking a portfolio company to market in 2026, the "Adjusted EBITDA" game has changed. The days of burying recurring operational costs under the label of "one-time transformation expenses" are finished. Buyers, burned by the valuation inflations of 2021-2022, have weaponized their Quality of Earnings (QofE) processes. They aren't just looking for accuracy; they are looking for reasons to retrade.

The data is stark. Recent 2025 studies indicate that 63% of buyers discovered material financial discrepancies during due diligence that were not disclosed in initial materials. When a buyer finds a discrepancy, they don't just subtract that dollar amount from the purchase price—they apply a multiple to it. A $200k "red flag" add-back at a 12x multiple isn't a $200k problem; it's a $2.4M reduction in enterprise value.

For Operating Partners, the mandate is clear: You cannot rely on a banker's "marketing EBITDA" to hold up under scrutiny. You need a defensible, operator-verified number before you ever sign an LOI. The gap between "Management Adjusted EBITDA" and "Buyer Adjusted EBITDA" is where deals die. This guide categorizes exactly which add-backs are passing due diligence in the current market, and which ones are triggering immediate retrades.

The Defensibility Matrix: What Survives QofE?

Not all add-backs are created equal. In our work preparing Revenue Quality Audits for exit, we classify adjustments into three tiers: Standard (Green), Aggressive (Yellow), and Toxic (Red). Understanding this distinction is the difference between a smooth close and a 90-day diligence war.

Tier 1: Standard Adjustments (Green)

These are universally accepted if documented. Buyers expect these, but they still verify the math.

• Owner Expenses: Personal cars, country club memberships, and family travel. Condition: You must prove these costs will disappear post-close.
• One-Time Professional Fees: Legal settlements (non-recurring) or M&A advisory fees. Condition: Cannot be related to ongoing litigation or standard compliance.
• Severance & Recruitment: Costs associated with specific, non-recurring reduction-in-force (RIF) events. Condition: Cannot be "annual pruning" of the sales team.

Tier 2: Aggressive Adjustments (Yellow)

These trigger scrutiny. Buyers will accept them only with bulletproof data, often requiring a "bridge" analysis.

• Pro Forma Synergies: "We implemented a new ERP in Q4, so we are adding back the inefficiency costs of Q1-Q3." Risk: Buyers view this as execution risk, not financial fact.
• New Hire Ramp: Adding back the revenue "lost" because a sales rep wasn't fully ramped. Risk: Unless you have historical ramp data proving 100% certainty, this gets slashed.
• Inventory Write-Downs: Claiming obsolete inventory was a "one-time clean-up." Risk: If you write down inventory every 2 years, it's a recurring cost of goods sold (COGS).

Tier 3: Toxic Adjustments (Red Flags)

These are deal-killers. They signal to the buyer that management is dishonest or incompetent.

• "Poorly Performing Locations": Adding back the losses of a branch you haven't closed yet.
• "Management Distraction": Claiming a bad quarter was due to the CEO being focused on a lawsuit or personal issue.
• Unfilled Roles: Adding back the profit you would have made if you had hired that VP of Engineering sooner. This is phantom EBITDA.

The "Sell-Side QofE" Premium

The most effective defense against price chipping is offense. Data from 2025 shows that sellers who commission a Sell-Side Quality of Earnings report achieve an average valuation multiple of 7.4x, compared to 7.0x for those who don't. That is a 0.4x turn of EBITDA—purely for doing the homework.

Action Plan for Exit Readiness

1. Audit Your Add-Backs Now: Do not wait for the banker. Review your last 12 months (LTM) adjustments. If an add-back relies on "narrative" rather than invoices, remove it.
2. Convert "Soft" to "Hard": If you have a "technology improvement" add-back, validate it with pre- and post-implementation labor costs. Turn assumptions into arithmetic.
3. Pre-Kill the Red Flags: If you have a "toxic" add-back on the books, remove it before the buyer sees it. Presenting a cleaner, lower EBITDA is better than presenting an inflated one that gets shredded—destroying your credibility in the process.

Your credibility is an asset class. When a buyer trusts your numbers, they look for reasons to close. When they find phantom add-backs, they look for reasons to walk. Don't give them the ammunition.