Sell-Side Quality of Earnings: A Critical Part of Due Diligence
By Richard Botham, CPA, MST, Partner, Assurance and Transaction Advisory Services
When it comes to selling a business, making the sale quicker, more efficient, and more lucrative is always in the seller’s (“you” or “your”) interest. But when trying to achieve the perfect deal, the critical step that many business owners often overlook is conducting a Quality of Earnings (QofE) analysis before going to market.
A QofE analysis is a detailed look at the financial health of a business and can uncover potential red flags or areas of concern for sellers before potential buyers begin their due-diligence process. By conducting a QofE prior to putting your business on the market, you not only gain a better understanding of your business financials but also increase the chances of a successful sale and potentially achieve a higher selling price.
In this article, we will explore the importance of a QofE analysis and why it should be a top priority for business owners looking to sell.
What is a quality of earnings report?
In short, a due diligence process designed to establish quality of earnings entails a thorough financial analysis of your company. It typically includes an analytical review of the company’s financial statements as well as a detailed analysis of its revenue, expenses, and profits. It also includes an assessment of the company’s management, operations, and head count. The due diligence process is typically performed by a financial expert and is intended to provide insight for potential buyers, investors, or lenders to assist them in making informed decisions about the company’s value and potential for success.
A quality of earnings report gives the seller and buyer an overview of the company’s financial performance, a detailed analysis of the company’s revenue, expenses, and normalized earnings, and summarizes any findings or recommendations from the analysis. It also gives the buyer an understanding of how much net working capital is required to run the business and at what point they may need to invest additional capital to maintain or advance operations.
The difference between a QofE report and a financial audit or review
Owners and/or management of companies that have annual audits or reviews of their financial statements may ask why a QofE report is necessary in addition to the assurance services already performed on their financial statements. The answer is that having both paints a more thorough picture of your company to a buyer. Audits and reviews may show that the company has an established history of good financial performance and compliance with GAAP, but there is a lot more buyers need to know about a company before making the decision to move forward with an offer.
QofE reports are different because instead of only focusing on historical results, they establish the expected sustainable earnings. This is accomplished by identifying and recording normalization, that is, non-recurring and pro-forma adjustments, as deemed applicable. The sustainable earnings will help to establish the company’s value today and assist the buyer in projecting the value in coming years. Overall, QofE is meant to be complimentary to a company’s financial reports (including audits or reviews) and help a potential buyer obtain a complete picture of a company, including its expected sustainable earnings. In other words, a QofE report speaks to what buyers really care about in making an investment decision.
Additionally, if your company does not receive an annual audit or review, the QofE can bring significant value. Often times, accounting errors or noncompliance with U.S. GAAP can be identified and corrected during a sell-side due diligence process and prior to going to market. This is extremely important because if either of these are found during a potential buyer’s due diligence process, it may significantly impact the estimated enterprise value of the company, the timeline of completing a deal, and perhaps most importantly, the trust the buyer has in the seller.
Your QofE team
When you go the proactive route and decide to engage for a QofE report before selling your business, you will need to bring in several key members of your broader business team to help anticipate which details to include and uncover the history necessary to make the report accurate and meaningful for potential buyers. That includes:
- The business owner or CEO: As the business owner or CEO, you have valuable insight and information about the company’s history, operations, financials, and growth potential.
- An M&A advisor or investment banker: An M&A advisor or investment banker can help guide the QofE process, identify potential buyers, and negotiate the sale of the business.
- An accountant or financial analyst: An accountant or financial analyst can perform the QofE analysis, provide comments on the company’s financial statements, and identify any adjustments or add-backs to the financials (generally EBITDA) that may be necessary to more accurately reflect the company’s true earning power.
- An M&A lawyer: A lawyer can help review and manage any legal or regulatory compliance issues that need to be addressed before the sale.
- A tax specialist: A tax specialist, either an accountant, a lawyer, or both, can help structure the deal in a tax-efficient manner and model your after-tax proceeds, that is, what cash you will walk away with.
- A management consultant or industry expert: A management consultant or industry expert can help to provide industry insights and identify areas of the business that are performing well and have the potential for growth, which can increase the perceived value of the business to potential buyers.
Depending on the size and complexity of the business, additional team members such as an IT consultant, HR consultant, and other specialized experts may be added to the team. Additionally, the team members may vary depending on the stage of the process and the specific needs of the business.
Sell-Side QofE reports boosts purchase price
The price of your company will often be based on a multiple of the company’s earnings (generally EBITDA) – companies that earn more will be valued higher. The sell-side QofE engagement team performs a deep analysis of monthly trends within the company’s financials to identify certain expenses the company paid that are add-backs to EBITDA – items that will not be included in the profit and loss statements in the hands of the buyer – that increase the company’s earnings and profitability, and by extension, increase the deal’s value by the multiple a buyer uses to value the company. Common addbacks include non-recurring or overstated items such as above market owner compensation, rent modifications, personal expenses, transaction consulting costs, and other discretionary expenses.
By performing a sell-side QofE, an opportunity is created to assist you in identifying all of the potential addbacks to adjusted EBITDA and present them to all prospective buyers. This gives you an advantage because the buyer’s team, during their due diligence process, is not incentivized to find add-backs that will increase the value of the deal. Therefore, a sell-side quality of earnings will provide you with confidence that addbacks will not go undetected and that you will achieve the best opportunity to maximize your deal value.
A clean & quick deal
To a buyer, a sell-side QofE report shows reliability, transparency, and efficiency on the part of the seller. This is advantageous to the seller for several reasons.
First and foremost, buyers generally bid higher on a business they see as clean. Many buyers are interested in hyper-specific industries, business sizes, and locations, which limits them to only a handful of feasible options. If you can show your business as the one that will be the most straightforward to purchase, it mitigates risk for the buyer thereby deriving value and resulting in a high first offer which can potentially drive bidding competition.
Second, sell-side QofE reports help deals come together and close more quickly. They signal that the seller already has the financial documents organized and prepared, meaning there will be less back-and-forth with the buyer. There will be fewer questions and document requests since much of the information will already be in the report, and sellers can pay closer attention to higher-level questions about the deal and continue running the business.
Getting a deal done faster also means less time for the deal to fall through. The biggest enemy of any acquisition is time – every day gives buyers another opportunity to find something wrong with the business or have something go wrong on their side. As a seller, saving time means increasing the chances a deal will close.
Know the problems before going to market
Surprises are never good when selling a business. When a buyer’s QofE report uncovers surprise matters and shows critical problems with the business during the due diligence process, it reduces the trust the buyer has in the business and it may decrease the value of the deal, and in some cases, could make them walk away resulting in a lost opportunity.
By doing a sell-side QofE, the seller becomes aware of any critical problems, giving them the option to either resolve them before going to market and/or communicate the problem to the buyer early on in the process before either party expends substantial time and energy. Communicating the problem up front not only adds transparency but also gives an opportunity to help the buyer understand the issue on your terms, leading to more constructive conversations as to how to move forward.
Sell-side quality of earnings reports have become commonplace in M&A acquisitions and for a good reason. Sellers, through their M&A advisors and investment bankers, are realizing that they increase deal value by identifying all appropriate addbacks to EBITDA, ensuring that all addbacks are substantiated and can withstand buyer diligence, and confirming that the financial information is organized and compliant with standards. All of these factors will add credibility to your business and could potentially significantly increase your deal price. A thorough QofE process could potentially add hundreds of thousands or millions of dollars to the purchase price. Additionally, the process eliminates many of the risks incumbent upon the sale of a business and can lead to a more streamlined buyside diligence process, a quicker close, and fewer broken deals. Ultimately, sell-side due diligence is an investment in a sale that can – and likely will – pay for itself many times over.