Normalize the Business You're Buying: The Missing Expense Problem in Small-Business M&A

Related reading: The 5 Most Common EBITDA Adjustments Sellers Try to Get Away With and EBITDA Addbacks Explained.

One of the most familiar concepts in small-business M&A is the addback.

For example, there’s the seller who runs personal expenses through the company. Or that one-time legal bill that distorts earnings. Or the owner paying themselves an above market salary, etc..

A buyer then adjusts those expenses for estimating the earnings that the business can reasonably be expected to generate after closing. But normalization works in both directions.

Sometimes the problem is not an expense that should disappear. Sometimes it is an expense that should be on the books … but isn’t.

I ran into a memorable example of this while analyzing a veterinary clinic for purchase.

The clinic's historical aftercare and animal-disposal costs were remarkably low. On the surface, that looked like a plus. Most veterinary practices incur recurring costs associated with transporting, cremating, or otherwise handling animal remains after euthanasia.

This clinic had found a cheaper solution.

The owners personally owned rural property outside town. On that property, they also maintained their own cremation capability. Instead of regularly paying an outside provider, the clinic could handle much of the process internally.

As a result, an expense that would normally appear on the income statement was largely absent.

The land and cremation facility belonged to the sellers personally and were not part of the veterinary clinic transaction. Once ownership changed, the clinic would need another solution.

Based on the likely replacement cost, the missing expense ran somewhere between $25,000 and $40,000 a year.

The historical financial statements were not factually wrong.

But historical EBITDA, in this case, was not representative of the business we were actually purchasing.

That distinction is at the heart of quality of earnings.

Historical Accuracy Is Not the Same as Economic Normalization

Financial statements are designed primarily to record what happened.

Quality of earnings asks another question: What earnings are reasonably sustainable under the ownership structure that will exist after closing?

Those two answers are not always the same.

A business can accurately report that it spent almost nothing on a particular service during the seller's ownership. But if that low cost depends on something personal to the seller that will disappear at closing, the buyer cannot reasonably assume the historical expense level will continue.

That means the historical P&L may be accurate while the historical EBITDA is still a poor representation of future economics.

This is especially important in small and lower middle market businesses because the dividing line between the company and its owners can be surprisingly blurry.

Owners commonly provide resources to their businesses outside normal commercial arrangements. They may work without market compensation, use personally owned property, lend equipment to the company, provide storage, share employees across entities, or draw on personal relationships to obtain unusually favorable pricing.

Those arrangements may work perfectly well for the current owner.

They are not necessarily transferable to a buyer.

The Missing Expense Problem

I think of these situations as missing or understated recurring expenses.

A missing expense exists when the company receives an ongoing economic benefit without bearing the full market cost of that benefit in its historical financial statements.

What’s important here is not whether the accounting is technically correct.

The important question is whether an unrelated buyer would have to spend more money to recreate the same capability after closing.

If the answer is yes, normalized earnings should reflect that cost.

This is the mirror image of a traditional addback.

With an addback, a historical expense is removed because the buyer is not expected to incur it.

With a missing expense adjustment, a cost is introduced because the buyer is expected to incur it, even though the seller historically did not.

You could call it an add-in.

The objective is the same in either direction: Estimate the recurring economics of the business under normal ownership.

This Happens Far Beyond Veterinary Practices

The crematorium made the veterinary case memorable, but the underlying issue shows up across small business industries generally.

Consider a few examples:

• A contractor stores equipment for free on acreage owned personally by the seller. A buyer will need to lease a yard.
• A distributor operates from a building owned by the seller and pays substantially below-market rent.
• A business owner's spouse performs bookkeeping, payroll, or administrative work for little or no compensation.
• The owner personally performs sales, estimating, purchasing, or general management functions but takes distributions rather than a market salary.
• A company uses trucks, machinery, warehouse space, software, or equipment that technically belongs to another entity controlled by the seller.
• Several businesses under common ownership share employees or overhead, but the company being sold does not bear its full share of those costs.
• A company benefits from unusually favorable vendor pricing that depends on purchases made across the seller's other businesses.
• The owner provides insurance, licensing, technical credentials, guarantees, or specialized capabilities that will need to be replaced after closing.

None of these arrangements are automatically improper.

Some are perfectly rational ways for an entrepreneur to operate several related assets.

The problem arises when a buyer values the company as though the benefit will continue indefinitely when it will not.

Why Missing Expenses Matter So Much in a Transaction

A relatively modest recurring expense can produce a much larger valuation impact.

Suppose a business reports $1 million of EBITDA. During diligence, the buyer determines that the company will need to incur an additional $75,000 of annual operating expense after closing. Normalized EBITDA becomes approximately $925,000.

If the transaction is being valued at five times EBITDA, that $75,000 normalization adjustment can translate into roughly $375,000 of enterprise value.

The economic effect continues after closing as well. If the buyer ignores the adjustment and pays a price based on $1 million of EBITDA, the business may immediately underperform the earnings level used to justify the purchase price.

That is why normalization is not merely an accounting exercise. It connects directly to valuation, purchase price negotiations, financing, debt service capacity, and the buyer's post-close operating plan.

How Buyers Find Missing Expenses

Missing expenses are often harder to identify than obvious addbacks because there may be no large transaction sitting in the general ledger waiting to be questioned.

Sometimes the clue is precisely the opposite: There is surprisingly little activity in an account where you would expect there to be more.

Good diligence therefore requires more than scanning the P&L for unusually large numbers. It also requires asking whether any numbers look unusually small.

Industry knowledge helps. If most businesses of a certain type normally pay for a service and the target barely does, that difference deserves investigation.

Site visits can be especially valuable. Physical operations often reveal economic dependencies that are difficult to see in accounting records. A warehouse on adjoining property, equipment parked at an owner's residence, shared personnel, or an unusual operating setup may lead to questions that would never arise from reviewing a spreadsheet alone.

Management interviews matter for the same reason. Buyers should look past what the company spends and, instead, understand how it actually operates.

• Who owns the real estate?
• Who owns the equipment?
• Which employees work for multiple related entities?
• What does the owner personally do each week?
• Are family members providing services?
• Does another company owned by the seller pay any expenses on behalf of the target?
• Are there services the company receives without a formal invoice?
• Which operating arrangements will change the moment the seller leaves?

Those questions help move diligence from bookkeeping toward economics.

How to Quantify the Adjustment

Finding a seller-specific benefit is only the first step. The next challenge is determining what it actually costs to replace.

The adjustment should not be an arbitrary number selected simply because a buyer believes an expense is too low. The best normalization adjustments are grounded in evidence.

In the veterinary example, the relevant question was not, "What amount should we insert because cremation expense looks suspicious?"

It was: What will an unrelated buyer reasonably have to spend to obtain the same service?

That can often be answered through vendor quotes, market compensation studies, comparable lease rates, existing service agreements, historical invoices from similar operations, or other observable market information.

The analysis should also reflect the actual operating model the buyer expects to adopt.

Suppose a seller performs several management functions personally. A buyer may not need to hire three people to replace those functions. Perhaps one experienced general manager can absorb all of them.

Likewise, if a seller provides free warehouse space, the appropriate adjustment should reflect the amount and type of space the business really requires. It should not automatically replicate the seller's exact property.

The goal is not to recreate the seller's arrangement.

The goal is to estimate the reasonable recurring cost of operating the acquired business going forward.

Be Careful Not to Double Count

Normalization also requires discipline.

If a buyer adjusts owner compensation to reflect the cost of hiring a replacement manager, the analysis should ensure the same duties are not being captured again through another labor adjustment.

Similarly, a below-market related-party lease may already include certain utilities, maintenance costs, or property expenses. Replacing the rent with a market rate and then separately adding every associated property cost could overstate the adjustment.

Each normalization should therefore answer three questions: What economic resource is the business receiving? Will that resource continue after closing? If not, what is the incremental recurring cost of replacing it?

Thinking in those terms helps prevent both missed costs and double counting.

Buyers Should Build a "Day One" P&L

One useful way to approach this issue is to mentally move the transaction forward.

Imagine the seller handed over the keys tonight. Tomorrow morning, the buyer owns the company.

• What has changed?
• Which people are gone?
• Which assets are unavailable?
• Which contracts need to be replaced?
• Which services now require outside vendors?
• Which rent, salaries, insurance, software, equipment, storage, or administrative functions must be added?

That exercise creates something close to a Day One operating P&L. It does not replace a detailed quality of earnings analysis, but it gives you a working framework for identifying costs that historical financial statements may not reveal.

The farther the Day One cost structure differs from the seller's historical cost structure, the more important normalization becomes.

Sellers Should Address These Issues Before Going to Market

This is not exclusively a buyer-side issue. Owners preparing to sell should identify these arrangements before diligence begins.

If the business occupies personally owned real estate at below-market rent, determine a reasonable market rent.

If family members perform meaningful work without compensation, quantify what replacement labor would cost.

If the company uses personally owned equipment, determine whether the equipment will transfer with the business or whether the buyer will need an alternative.

If the owner provides significant day-to-day operational services, distinguish between true owner compensation addbacks and the cost of replacing necessary management functions.

Doing this before a sale process helps sellers present a more defensible normalized EBITDA figure. It also reduces the likelihood that the buyer discovers the issue late in diligence and treats it as an unpleasant surprise.

Good sell-side preparation does not mean maximizing every possible addback. It means presenting earnings that a sophisticated buyer can actually believe.

Quality of Earnings Is About Transferable Economics

This is ultimately the broader lesson from the veterinary clinic example.

The low historical cremation expense was real.

But so was the seller-owned ranch. So was the personally controlled cremation capability. And so was the fact that neither automatically transferred with the veterinary practice.

A buyer valuing the clinic had to distinguish between the economics of the business being purchased and the economics of the seller's broader personal ecosystem.

That distinction exists in thousands of small businesses. Entrepreneurs frequently build their operations around the resources, relationships, property, labor, and capabilities available to them personally. There is nothing inherently wrong with that. But when ownership changes, some of those advantages disappear.

A quality of earnings analysis should identify them before the purchase price is finalized, because sustainable EBITDA is not simply whatever number appears at the bottom of the seller's historical income statement. It is an estimate of the earnings power that actually transfers to the buyer.

And that leads to one of the more useful rules in small business diligence: Normalize the business you are buying, not the business the seller happens to operate today.

Frequently Asked Questions

What is a missing expense in a Quality of Earnings analysis?

A missing expense is a recurring cost the business does not fully bear in its historical financial statements even though an unrelated buyer is likely to incur that cost after closing. It is the mirror image of a traditional addback: instead of removing a historical expense, the analysis introduces a recurring cost needed to operate the acquired business normally.

Why can accurate historical financials still overstate sustainable EBITDA?

Historical financial statements record what happened under the seller's ownership. If the seller provided property, labor, equipment, storage, services, or favorable related-party arrangements that will not transfer to the buyer, the historical P&L can be accurate while still understating the buyer's future operating costs.

What are common examples of missing or understated recurring expenses?

Examples include below-market related-party rent, unpaid or underpaid family labor, owner management duties that require replacement, personally owned equipment or storage, shared employees or overhead across related entities, and seller-specific vendor pricing or credentials that will disappear after closing.

How should a buyer quantify a missing expense adjustment?

The adjustment should reflect the reasonable recurring replacement cost under the buyer's expected operating model. Useful evidence can include vendor quotes, market compensation studies, comparable lease rates, service agreements, and historical invoices from similar operations.

What is a Day One P&L in acquisition diligence?

A Day One P&L is a practical way to think about the cost structure immediately after ownership changes. The buyer asks which people, assets, contracts, services, rent, salaries, software, equipment, storage, or administrative functions must be added or replaced once the seller leaves.

Should sellers address missing expenses before going to market?

Yes. Sellers can reduce late-stage surprises by identifying non-transferable benefits before diligence begins, estimating reasonable market replacement costs, and presenting normalized EBITDA that a sophisticated buyer can defend rather than simply maximizing addbacks.