Quality of Earnings in M&A – The Ultimate Guide

Introduction

Over the course of many decades, astute buyers have recognized the immense value in commissioning professionals to conduct a rigorous Quality of Earnings (QoE) analysis of target companies slated for acquisition. This invaluable tool not only offers buyers peace of mind but also forms the bedrock upon which they determine the fairness of the proposed business purchase price.

In a noteworthy shift, sellers have increasingly embraced the practice of proactively funding sell-side QoE reports before embarking on the sales journey. In fact, it has become the prevailing norm for nearly all but the smallest M&A transactions – and with compelling rationale.

I have personally witnessed the transformative impact of these sell-side reports, which extend benefits to sellers in manifold ways. They provide a dry run of due diligence, instill confidence in potential buyers, facilitate early issue resolution, bolster negotiating leverage, and elevate the ultimate sales price. It’s imperative, however, to grasp that a QoE analysis and a conventional audit serve distinct purposes; some mistakenly assume that an audit suffices. Allow me to delineate these differences, expound on the merits of each, and elucidate when it’s judicious to opt for an audit versus a comprehensive QoE report.

Executive Summary

Definitions

• Quality of Earnings Report:  meticulous examination of a selling company’s financial records carried out by an impartial, third-party professional. This comprehensive report serves to validate stated EBITDA figures, scrutinize projected financial performance, and gauge the sustainability of both revenue and earnings. It encompasses a multifaceted assessment, encompassing factors such as asset quality, net working capital, accounting practices, debt and debt-related items, verification of cash and revenue, financial oversight and reporting, supply chain robustness, and the competence of the management team.
• The Quality of Earnings Team: comprising independent experts, the Quality of Earnings team is engaged to compile the QoE report. Their impartial stance ensures an objective evaluation, untainted by any vested interests or external pressures, thus upholding the integrity of the analysis.

Types of QoE Reports: Buy Side vs. Sell Side

There are two primary categories of QoE reports, with similar core content:

• Buy Side: Initiated and financed by the acquiring party, the buy-side report is commissioned by the buyer.
• Sell Side: Commissioned and funded by the selling entity, the sell-side report is requested by the seller.

Audit vs. QoE Analysis

It’s vital to distinguish between an audit and a QoE analysis, as their objectives diverge significantly:

• QoE: Primarily geared towards facilitating M&A transactions, a Quality of Earnings analysis is a specialized assessment conducted by CPAs well-versed in the priorities of potential buyers. It identifies critical issues that necessitate resolution before entering the market.
• Audit: In contrast, an audit’s primary objective is to ascertain compliance with generally accepted accounting principles (GAAP) and validate the accuracy of financial statements.

How a QoE Report Fits Into the M&A Process

1. Negotiations
2. Letter of Intent
3. Commencement of Due Diligence
   • Quality of Earnings Analysis – As an integral component of their financial due diligence (FDD) process, the majority of buyers engage an impartial third party to undertake a comprehensive Quality of Earnings (QoE) analysis. This analysis serves the critical purpose of validating the actual cash flow, often represented as EBITDA, generated by the target business. The QoE report is typically prepared subsequent to the execution of the Letter of Intent (LOI), marking the initiation of an exclusivity period during which due diligence activities are diligently pursued.
4. Conclusion of Due Diligence
5. Closing
6. Transition and Integration

Advantages of the QoE Analysis

Here’s a concise overview highlighting the primary objectives and benefits of a Quality of Earnings (QoE) analysis:

Advantages of the QoE – for the Seller

• Identifies Opportunities for Additional EBITDA Adjustments
• Enhances Negotiating Leverage
• Pinpoints and Resolves Issues Ahead of Market Entry
• Acts as a Dry Run for Due Diligence
• Supports Achieving a Premium Purchase Price
• Establishes Favorable Net Working Capital Targets
• Streamlines Document Preparation for Due Diligence
• Demonstrates Commitment to Prospective Buyers
• Boosts Buyer Confidence and Interest

Advantages of the QoE – for the Buyer

• Provides a Post-Closing Roadmap for Issue Resolution
• Assists in Estimating Available Bank Financing
• Ensures Thorough and Rigorous Due Diligence

Benefits of the Quality of Earnings (QoE) Analysis – Mutual Advantages

• Fosters a Deeper Insight into the Business
• Enhances the Probability of a Successful Deal Closure
• Confirms EBITDA Accuracy Through Expert Validation
• Establishes a Trustworthy Foundation for Future Projections
• Provides an Unbiased, Independent Evaluation
• Mitigates the Potential for Post-Closing Working Capital Disputes
• Streamlines the Deal Timeline

The Parties’ Objectives

Sell-side Quality of Earnings (QoE) reports have evolved into a standard practice, virtually becoming a requisite for transactions of substantial scale, leaving no room for exceptions. Embracing a sell-side QoE report is no longer merely a matter of choice; it’s a strategic imperative. It’s important to note that both public and private equity buyers now demand this level of scrutiny for deals surpassing a certain threshold.

The advantages of procuring a sell-side QoE report are manifold:

• Bolsters Buyer Confidence: A QoE report signals to potential buyers that you’re a serious, well-prepared seller, instilling confidence in your business’s integrity.
• Proactive Issue Resolution: By revealing and addressing potential issues upfront, it streamlines the transaction process, reducing the likelihood of last-minute complications.
• Accelerates Deal Timeline: Early issue identification and resolution contribute to a smoother, more efficient transaction, expediting the overall timeline.
• Transparent Business Evaluation: Sellers gain valuable insights into their own businesses before entering the market, affording them the opportunity to proactively address any discrepancies or areas of concern.
• Effective Issue Communication: Armed with a QoE report, sellers are better equipped to discuss and explain any concerns to potential buyers, fostering smoother negotiations.
• Safeguards Against Surprises: By eliminating unexpected surprises, such as unfavorable adjustments or deal-breakers, it safeguards the purchase price and ensures deal continuity.
• Enhanced Valuation: The QoE analysis may unveil additional adjustments that can augment the business’s valuation, potentially leading to a more favorable deal.

Meanwhile, on the buy-side, a QoE report serves the following key objectives:

• Validates Earnings (EBITDA): Ensures the accuracy and reliability of earnings figures, instilling buyer confidence.
• In-Depth Financial Understanding: Provides a comprehensive view of account balances, cash flows, and other pertinent financial aspects, aiding in informed decision-making.
• Operational Insight: Offers valuable insights into the day-to-day operations of the business, fostering a deeper understanding of its intricacies.
• Financing and Approval Support: Can be instrumental in securing financing or gaining approval from boards or investment committees, substantiating the viability of the transaction.

Sell-side QoE reports are becoming standard, so not having one puts you at a disadvantage.

The QoE Analysis Process

Step 1: Gathering Information

Begin by meticulously collecting and organizing the essential data required for the analysis. Primary sources include:

• Historical financial statements
• Interim financial statements
• Forecasted financial information
• Tax returns
• Bank statements
• Insights garnered from management interviews

Step 2: Preliminary Analysis and Discussion

Engage in discussions with the management team to address and elucidate key issues.

Step 3: Adjusting the Financial Statements

Effortlessly enhance clarity by eliminating non-recurring revenue and expenses, ensuring that the financials exclusively reflect the core business operations.

Step 4: In-Depth Analysis

Conduct a comprehensive examination of the business’s strengths and weaknesses. This holistic assessment equips buyers with the insights required for the most well-informed decisions. It may encompass a scrutiny of:

• Equipment age
• Workforce demographics
• Customer concentration
• Employee compensation structures
• Employee retention rates
• Inventory turnover rates
• Key employee-related challenges or risks
• Detailed trend analyses on a monthly and yearly basis
• Potential capital expenditure (CapEx) necessities
• Profit margins, categorized by customer, product, or service
• Vendor concentration levels

An adeptly prepared Quality of Earnings (QoE) report should encompass observations on each facet analyzed during the assessment.

Step 5: The Final Deliverable

While the format may vary, the finished product typically materializes as a PDF file or a structured spreadsheet. This report serves as the linchpin within a broader financial due diligence analysis, offering a lucid perspective on the company’s capacity to generate future cash flows, derived from its historical performance.

Scope, Timing, and Stakeholders

• Scope: The extent of the analysis is tailored to address the buyer’s specific concerns and the intricacy of the business.
• Timing: Typically spans a duration of 30 to 45 days, contingent upon the promptness of information provision and responsiveness of the owner or management team.
• Involvement of Other Stakeholders: The QoE report and financial due diligence findings are routinely disseminated to pertinent stakeholders, including lenders, private equity investment committees, and the boards of strategic buyers or public firms.

Tips for Hiring a QoE Provider

Type of Firm: QoE studies are typically carried out by either CPA firms or specialized financial due diligence firms.

Experience Matters: Opt for a firm boasting a dedicated team or department exclusively focused on QoE services. It’s imperative that this team possesses extensive experience in conducting financial due diligence processes within the realm of M&A transactions, preferably with a track record in your specific industry.

Reputation Counts: Place your trust in a reputable firm that can withstand the rigorous scrutiny of private equity or strategic buyer financial due diligence.

Independence is Key: Ensure that the firm conducting the QoE analysis is entirely distinct from the one responsible for preparing your financial statements, preserving an essential layer of independence.

Cost Expectations: Be prepared for costs to vary significantly based on several factors:

• Business size
• Adherence of financials to GAAP standards
• Clarity and accuracy of financial statements
• Business complexity
• Number of entities involved
• Industry sector

For smaller companies, a basic QoE report might cost around $5,000, while a comprehensive report for a mid-sized firm could exceed $100,000. In the eyes of private equity firms, well-established regional firms are often preferred for businesses generating between $10 million to $25 million in revenue. It’s important to recognize that the size and complexity of the firm you choose to hire will also impact the overall cost.

Use a reputable firm with the ability to withstand the rigors of private equity or strategic buyer financial due diligence.

Synonyms and Acronyms

Synonyms:

• Financial Due Diligence (FDD)
• Quality of Earnings Report
• Quality of Earnings Analysis

Acronyms:

• Q of E
• QofE
• QoE

What is a Quality of Earnings Report?

The Goal of the QoE Report

The paramount aim of a QoE report is to consolidate a comprehensive document that conveys the precision, excellence, and enduring nature of a company’s earnings.

“Quality” of Earnings

When it comes to financial statements, consistency, accuracy, and integrity are paramount. The QoE report delves into the target company’s financials, assessing the quality of its earnings as either low or high. Its core objectives include filtering out low-quality earnings, identifying and rectifying accounting irregularities, and making adjustments for one-time events.

• Low-Quality Earnings: Earnings that are tied up in accounts receivable, even if recognized, are deemed low quality. Similarly, earnings that have been inflated due to deferred maintenance are not considered high quality.
• High-Quality Earnings: On the flip side, earnings expected to recur reliably in the future are regarded as high quality. For earnings to achieve this distinction, financial statements must faithfully represent them, and, most importantly, they must be sustainable.

The aim is to compile a single document that presents the accuracy, quality, and sustainability of a company’s earnings.

Format and Contents

The structure and content of a Quality of Earnings (QoE) report can vary significantly, depending on the company’s size and the requirements of both the buyer and seller. It can range from being extensive and detailed to concise and focused.

Here is an outline of the major components commonly found in a typical Quality of Earnings report:

General Financial Statement Analysis

Every QoE report includes a thorough examination of the company’s financial statements. This encompasses an analysis of the income statement, an assessment of asset condition and valuation from the balance sheet, and, if available, an analysis of the cash flow statement.

Adjustments to Financial Statements

Income statements often undergo adjustments to ensure consistent representation of the company’s operations. For instance, adjustments may be necessary for the timing of bonuses, revenue recognition, or bad debt accounting.

Tax Returns

The report may also delve into an examination of the company’s tax positions and filings.

Operational Operational Risks

The QoE report delves deeper into the factors influencing business performance. This includes analyzing trends in revenue, margins, growth rates, and their potential impact on future earnings risks. The report may break down revenue by product lines or customers, assess customer concentration, and consider industry trends. It also evaluates risks related to products, services, distribution channels, and dependencies, such as key employees, intellectual property, and third-party suppliers. Pricing strategy, gross margin sustainability, and elasticity may also be assessed.

Related-Party Analysis

Companies may engage in significant transactions with related parties, i.e., entities within the same corporate family. Buyers often seek assurance that these transactions were conducted impartially. They may also want to ascertain that a change in business control won’t jeopardize critical relationships, such as those with customers or suppliers.

Quality of Records

Assessing the Quality of Accounting Records

The report should evaluate the consistency and integrity of the company’s internal controls. It should also consider recent changes in the company’s accounting policies and their potential impact on the quality of accounting records or reported EBITDA. The report may uncover unconventional trends in financial statement preparation, non-standard accounting policies, and alterations in accounting procedures over time, shedding light on their influence on earnings.

Validation of Revenue

Most Quality of Earnings (QoE) reports encompass a “proof of revenue” component. This involves verifying that the reported revenues on the income statement align with corresponding bank statements, ensuring the accuracy and transparency of revenue representation.

Validation of Cash

A routine bank reconciliation is often conducted to pinpoint any disparities between financial statements and bank records.

Income Statement

Revenue Recognition

The examination of revenue recognition, which pinpoints when revenue is recorded on financial statements, serves to validate that reported revenue aligns with the company’s accounting policies and Generally Accepted Accounting Principles (GAAP). Any deviations from these standards will be meticulously documented in the report, with a keen focus on how they impact EBITDA.

Profit Margins

The report also delves into the assessment of gross margins across the entire business and by individual product lines. It takes note of recent or anticipated changes in these margins and their potential implications for future earnings.

EBITDA Analysis

The Quality of Earnings (QoE) analysis meticulously guides the reader through the financial figures, tracing the path from net income to reported EBITDA and subsequently to adjusted EBITDA. The ultimate objective is to dissect and validate pro forma EBITDA, providing robust support for the purchase price or valuation of the target company.

Adjustments to EBITDA

A critical facet of the report involves the scrutiny and validation of adjustments made to arrive at adjusted EBITDA. Source documents undergo meticulous examination to ascertain the authenticity and reasonableness of these adjustments. In certain instances, there may be a need to normalize additional expenses, such as those incurred due to an extraordinary event like a flood at a plant. In such cases, net income would be adjusted to account for the flood-related expenses on the income statement, any revenue loss incurred, and capital expenditures linked to plant repairs. Normalization is crucial because events like the flood, being one-time occurrences, hold no bearing on the company’s future performance. Therefore, the adjusted EBITDA necessitates normalization to eliminate the impact of such unique events. This stands as a pivotal component within the QoE report.

Pro Forma EBITDA Adjustments

Furthermore, the report may introduce adjustments to the projected income statements, specifically tailored for the calculation of post-closing projected EBITDA. This proves especially beneficial for strategic buyers aiming to quantify potential synergies. These adjustments could encompass considerations for substantial contracts recently awarded, anticipated operational efficiency enhancements, cost reductions, or foreseeable revenue synergies. Alternatively, the buyer might wish to account for other factors set to change post-transaction.

Examples of such adjustments encompass revenue stemming from business lines that will cease post-closing, salaries of redundant employees slated for layoffs, facility closures, above-market compensation for owners, and loans or leases scheduled for payoff upon closing. In instances of significant contract wins or substantial operational improvements, the QoE report may delve into an analysis of their potential impact on historical financial statements. These adjustments typically find their place in a dedicated pro forma adjustment section of the report.

Free Cash Flow

Many buyers tend to opt for EBITDA as a straightforward substitute for free cash flow. While EBITDA offers a quick and convenient calculation, it doesn’t always provide an accurate representation of available cash for investors. This is especially true if the target company is subject to taxes, has working capital requirements, or plans to invest in long-term assets. When buyers seek to understand the actual cash flow accessible to stakeholders, it’s advisable to construct a free cash flow model. This model takes into account changes in working capital, capital expenditures, and tax considerations.

Projections

The Quality of Earnings (QoE) report may also incorporate projected or pro forma income statements. This analysis holds substantial importance because financial projections often hinge on assumptions that can be validated through the QoE report. Consequently, these projections gain a higher degree of reliability as they are founded on a robust basis and endorsed by an impartial entity. Pro forma income statements can serve various purposes, including the computation of future earnout payments, forming the basis for discounted cash flow valuation, and many other applications.

Balance Sheet

Net Working Capital (NWC) Analysis

In a Quality of Earnings (QoE) analysis, the examination of net working capital revolves around determining the amount required to operate the business smoothly without necessitating additional capital injections post-closure. It’s common practice in M&A transactions to operate on a cash-free, debt-free basis. This entails the seller retaining the cash on the balance sheet while settling any outstanding debts upon closing. The purchase price is then adjusted up or down, contingent on the variance between the required net working capital for business operations (referred to as the “net working capital target”) and the actual net working capital at the closing.

Balance Sheets

Furthermore, the QoE analysis delves into a meticulous assessment of the initial and concluding balance sheets. This scrutiny aims to ascertain whether revenues and expenses have been accurately recorded within the appropriate periods and if liabilities and reserves have been appropriately documented.

Debt

The report may also identify any outstanding debt within the business, evaluating its nature, whether it aligns with typical operational requirements, and whether it falls under the category of short-term debt, which the buyer should assume, or long-term debt, which should not be carried over to the buyer. Additionally, contingent liabilities may come to the fore, such as pending regulatory or legal disputes, underfunded pension plans, and deferred compensation plans.

The report should consider the quality and consistency of the company’s internal controls.

Advantages of the QoE Report

A Quality of Earnings (QoE) report serves various purposes and offers numerous advantages for both buyers and sellers.

Here’s a concise overview of the primary purposes and benefits of a QoE report:

For the Seller

Sell-Side Advantage #1 – Identifies Additional EBITDA Adjustments

The QoE report can uncover previously undiscovered EBITDA adjustments that boost profitability and, consequently, the overall value of the business.

Sell-Side Advantage #2 – Improves Negotiating Leverage

Conducting a QoE analysis empowers the seller to negotiate for a higher purchase price with confidence. It reassures the seller that their reported EBITDA and financial data are defensible and independently validated. Many buyers recognize that when a seller invests in a QoE report as part of their preparation, the buyer’s ability to negotiate down the purchase price due to financial inaccuracies uncovered during due diligence is limited.

Sell-Side Advantage #3 – Identifies Problems That Can Be Resolved in Advance

The QoE report pinpoints issues that can be addressed early in the process. Resolving these concerns before entering the market allows for a more composed resolution, avoiding the high-pressure environment of a multi-million dollar transaction. Even if sellers opt not to resolve discrepancies before going to market, they are still well-prepared to explain them to potential buyers before they escalate into significant issues. This preserves trust and credibility with buyers.

For sellers, the report represents an opportunity to address any potential issues and gain insight into their business’s inner workings. This proactive approach significantly reduces risks and provides an impartial assessment of any potential concerns that should be addressed to maximize the company’s market value. Disclosing problems early in the process is a prudent strategy, enabling sellers to control the narrative. This is particularly crucial before accepting a Letter of Intent (LOI), especially when negotiating with multiple bidders. By preemptively disclosing issues, sellers allow bidders to consider these factors when making their final offers, potentially leading to greater acceptance of any identified issues, especially in a competitive bidding scenario.

If issues are discovered after accepting the Letter of Intent (LOI), you risk losing your negotiating edge, as there will typically be only one buyer left in the picture. This remaining buyer will wield considerable leverage, possibly proposing a reduction in the purchase price or even opting to withdraw from the deal altogether. The discovery of significant undisclosed matters can raise doubts about what else may have been concealed. This heightened skepticism may prompt the buyer to conduct more rigorous due diligence and introduce stringent provisions into the transaction structure and purchase agreement to safeguard against undisclosed issues. Had these concerns been disclosed prior to the LOI, other bidders might not have been as alarmed, potentially avoiding unnecessary complications.

Sell-Side Advantage #4 – Improves Positioning

Having third-party validation in the form of a QoE report increases the credibility of your business and enhances its appeal to potential buyers. It presents your company as an attractive and wise investment opportunity.

Sell-Side Advantage #5 – Serves as a Practice Run for Due Diligence

Consider the sell-side QoE report as a valuable rehearsal for what you and your management team will encounter during the buyer’s due diligence process. Given that many sellers lack prior experience with due diligence, adequate preparation is paramount. Once a buyer expresses interest, providing access to an existing data room can expedite the process significantly compared to assembling all materials from scratch at that stage. Time is a critical factor in deal-making. Prolonged due diligence processes increase the likelihood of unforeseen events affecting the buyer’s interest and potentially derailing the deal. In reality, a deal remains uncertain until the purchase agreement is signed, and every day in between presents an opportunity for the deal to encounter obstacles.

A sell-side QoE report often results in a higher sales price.

Sell-Side Advantage #6 – Streamlines Your Preparation for Due Diligence

Engaging in the sell-side Quality of Earnings (QoE) process allows you to compile many of the documents and data that the buyer’s diligence team will request. By conducting a sell-side QoE analysis, you ensure that all necessary information is gathered before the buy-side initiates its own QoE analysis, expediting the entire process.

Sell-Side Advantage #7 – Enhances the Potential Purchase Price

A sell-side QoE report often results in a higher sales price. Since M&A transactions are valued based on earnings multiples, greater earnings translate to a higher business valuation. Identifying and resolving issues before entering the market leads to higher-quality earnings, ultimately resulting in a more favorable valuation for the business.

Sell-Side Advantage #8 – Equips You with a Diligence Advocate

The sell-side QoE team often conducts financial due diligence for buyers in other transactions, equipping them with the expertise to address critical accounting inquiries that may arise during the buyer’s due diligence. Typically, the sell-side team arranges a call with the buyer’s diligence team to address any questions that arise after reviewing the report. These calls often facilitate the swift resolution of contentious matters, which might be more challenging without an experienced M&A expert on your side.

While the report’s primary purpose is to provide an objective assessment of a company’s earnings, it can also be strategically wielded by potential buyers to challenge or reduce the purchase price. A prospective buyer may leverage their QoE report to push for adjustments in EBITDA or add-backs, thereby lowering the purchase price and potentially undervaluing the business. Having an experienced M&A advisor in your corner is crucial to counter buyer objections and navigate other issues, safeguarding against price reductions.

Without a sell-side QoE report, the buy-side QoE firm may have greater latitude to be aggressive in identifying accounting issues. In contrast, retaining a reputable firm to conduct a sell-side QoE analysis leaves less room for such adjustments. Even if the buy-side QoE firm raises concerns, you will have an advocate fluent in accounting language to negotiate a fair resolution.

Sell-Side Advantage #9 – Establishes a Strategic Net Working Capital Target

A sell-side QoE report also plays a pivotal role in determining the seller’s stance during negotiations regarding the appropriate net working capital target. Generally, sellers aim for a lower net working capital target, which minimizes the risk of a purchase price reduction due to discrepancies between the delivered net working capital and the target amount. It can pinpoint accounts that may warrant exclusion from the net working capital calculation for various reasons. While the objective definition of net working capital as current assets minus current liabilities exists, determining a specific target tailored to a unique situation involves negotiation. Having an advocate well-versed in setting net working capital targets becomes invaluable in this process.

Sell-Side Advantage #10 – Facilitates Clear Problem Resolution

M&A advisors, with their wealth of experience in guiding deals to successful closures, excel in presenting information in a manner that mitigates potential negative impacts on a deal’s viability. Equipped with a deeper understanding of your business’s strengths and weaknesses from a prospective buyer’s perspective, you gain a stronger negotiating position, effectively boosting your leverage in the deal-making process.

Sell-Side Advantage #11 – Streamlines Document Organization

Many documents required for due diligence are also integral to the QoE report. Engaging in a sell-side QoE report provides a head start in assembling these documents into a virtual data room in advance. This proactive approach accelerates the due diligence process and minimizes the risk of deal-disrupting issues arising before the closing.

Sell-Side Advantage #12 – Demonstrates Dedication to Potential Buyers

Investing time and effort into preparing a QoE report before entering the market sends a powerful message to investors – you are committed to selling your company. Prospective buyers appreciate your commitment, as they prefer to avoid investing significant effort in a deal only to have you retract your intent to sell at the eleventh hour.

For the Buyer

Buy-Side Advantage #1 – Charts a Post-Closing Pathway

For buyers, the QoE report serves as a detailed roadmap outlining the accounting policies and procedures that require attention post-closing, along with operational enhancements that can boost the business’s profitability. This invaluable guide streamlines the integration process, reducing transition hiccups and ensuring a smoother journey forward.

Buy-Side Advantage #2 – Refines Bank Financing Estimates

Banks scrutinize various financial metrics when assessing the feasibility and extent of financing for a deal. Understanding the target’s debt-servicing capacity is vital, and this is facilitated by the QoE report’s normalized EBITDA and net working capital assessments. The independent preparation of the report adds an extra layer of assurance, bolstering the bank’s confidence in the transaction.

Buy-Side Advantage #3 – Guarantees Rigorous Due Diligence

Equipped with the QoE report, prospective buyers can conduct a thorough examination of the target’s financial and operational landscape, ensuring there are no inflated earnings or unconventional accounting practices lurking in the shadows. This preemptive insight empowers buyers to make informed decisions before committing to the acquisition.

If the buyer discovers something material you failed to disclose, they’ll wonder what other issues you may have failed to disclose.

For Both Parties

Advantages for Both Parties #1 – Deepens Insight into the Business

Beyond the numerical data, the true goldmine lies in the narrative and elucidation that breathe life into the numbers. These insights provide both parties with a profound understanding of the business. For sellers, this report offers a robust foundation for gauging the company’s true value, bolstering their negotiation position. For buyers and sellers alike, it unveils critical facets of the company, including the strength of its internal controls, the prowess of its management team, key performance indicators, and factors that might uniquely impact the business, such as one-time events or unsustainable practices.

Buyers gain greater confidence in their comprehension of the business and the credibility of its financial statements. Enhanced certainty translates into reduced risk, often resulting in a more favorable purchase price. With a firmer grasp of the associated risks, it becomes easier to project the company’s performance with conviction, lending additional weight to prepared forecasts.

Advantages for Both Parties #2 – Boosts Buyer Confidence and Enthusiasm

In the realm of negotiations, buyers tend to have a spectrum of prices they are willing to offer. Should they perceive a business as fraught with unreliable accounting records and intricate hurdles, their bids may gravitate towards the lower end. Conversely, when buyers delve into the sell-side QoE report, develop trust in the accuracy of the financial records, and discern a business free from apparent obstacles, they become inclined to offer bids on the higher side. A buyer may be more inclined to pay a premium multiple for the same earnings if the deal appears straightforward and easy to execute. This distinction of an extra multiple or two on earnings can translate into millions of dollars in favor of the seller in transaction valuation.

Buyers are inclined to be more generous in their offers when they perceive a business as clean and appealing. Furthermore, the market-dictated multiple is influenced by the number of interested buyers. If the seller can furnish a QoE report that reinforces the desirability of the deal, it is likely to attract a larger pool of interested buyers. In contrast, without a sell-side QoE report, market interest might still exist but could be less robust, exerting downward pressure on the valuation.

Advantages for Both Parties #3 – Enhances the Likelihood of a Successful Closing

QoE firms align financial statements with the buyer’s perspective, alleviating misunderstandings or discrepancies related to accounting interpretations. This harmonizes understanding across the board concerning accounting policies, including accrual vs. cash methods, revenue recognition policies, and more. Most private equity buyers employ debt for transaction funding, a key driver of the purchase price. Lenders typically require sellers to undergo QoE studies before finalizing term sheets. Hence, conducting a QoE analysis early in the process ensures that valuations presented in Letters of Intent (LOIs) are more precise and accurate. This heightened precision significantly bolsters the likelihood of a successful closing.

Advantages for Both Parties #4 – Confirms EBITDA Accuracy

The QoE report serves as a beacon of truth, illuminating the genuine earnings potential of the business and providing a clear picture of its historical financial performance. Given that EBITDA multiples are the cornerstone of valuation methodologies, an independent validation of the stated EBITDA helps solidify the business’s worth and the price it commands.

Advantages for Both Parties #5 – Establishes a Robust Foundation for Projections

Ultimately, prospective buyers gauge a business’s value based on its anticipated future performance and the accompanying forecasts, which hinge on underlying assumptions. With the QoE report validating these fundamental assumptions, it bolsters confidence in the accuracy of the forecasts. Since most forecasts rely on recent financial data, furnishing reliable EBITDA and cash flow figures enhances forecast precision, further reinforcing faith in the projections.

Advantages for Both Parties #6 – Provides an Unbiased View

An external firm injects objectivity into the transaction, capable of identifying common concerns that might raise eyebrows among buyers. It acts as a vigilant guardian, spotlighting potential issues that might elude the awareness of management. The QoE report offers both parties an impartial assessment of potential red flags or areas warranting scrutiny.

Advantages for Both Parties #7 – Reduces Post-Closing Working Capital Disputes

One potential battleground post-transaction closure revolves around disputes concerning net working capital. The sell-side QoE team collaborates with legal counsel from both sides to scrutinize the purchase agreement and ensure it comprehensively addresses any contingencies related to net working capital calculations. M&A accounting and legal experts are better poised to craft documents that mitigate litigation risks.

Advantages for Both Parties #8 – Accelerates the Deal Timeline

Many buyers hesitate to engage legal counsel to draft closing documents until the QoE report is finalized, wary of unearthing critical issues that could imperil the transaction. A preemptive sell-side QoE analysis instills confidence in buyers, potentially expediting the overall transaction timeline.

A buyer may be willing to pay a higher multiple on the same earnings if the deal appears to be clean and easy to transact.

Red Flags

One major strength of the QoE report lies in its ability to empower the seller to proactively address and resolve potential issues before entering the market. Neglecting these warning signs can significantly impact the company’s valuation and its prospects for future performance.

Here’s a concise overview of some of the most prevalent issues uncovered during a QoE analysis:

• Aggressive Accounting Practices: Some owners may adopt aggressive accounting tactics to either artificially boost earnings for valuation purposes or deflate them to minimize tax liabilities. The QoE report plays detective, exposing such maneuvers and offering strategies for resolution.
• Unreconcilable Data: When financial statements fail to align with bank statements or tax returns, it’s crucial to unearth the underlying reasons. The QoE report highlights disparities between these documents, paving the way for reconciliations.
• Improper Revenue Recognition: Revenue often gets recognized in incorrect periods due to ambiguous accounting policies or processes. Additionally, overlooking revenue, rebates, discounts, or returns in the right time frame can lead to issues. The QoE report addresses these inconsistencies and provides recommendations.
• Inappropriate Expense Capitalization: Only long-term expenses should be capitalized, but sometimes, companies blur the line. The report pinpoints items that should have been expensed and any incorrectly capitalized expenses.
• Non-GAAP Accounting: Maintaining adherence to generally accepted accounting principles (GAAP) ensures uniformity and guards against unintentional or deliberate financial misrepresentation. The QoE firm identifies deviations from GAAP and may suggest restatements if necessary.
• Flawed Inventory Tracking: Inaccurate inventory management impacts key financial metrics like cost of goods sold, gross margins, and EBITDA. Mishandling ending inventory balances can lead to EBITDA understatements or overstatements, signaling operational or accounting deficiencies.
• Related-Party Transactions: Many companies engage in transactions with affiliates within their corporate network, often lacking the impartiality of arm’s-length dealings. Such transactions can distort revenue and expenses, potentially facilitating income inflation. For instance, a company might “sell” a product to a related entity, manipulate transaction terms, or conduct business with related parties at artificially inflated or discounted rates.
• Undisclosed or Potential Liabilities: Examples of these hidden financial burdens include unaccounted bad debts, goods mistakenly classified as inventory, or pending lawsuits. Such liabilities can represent future commitments for the company, often omitted from its balance sheet.
• Customer Dependency Concerns: Another issue arises when a substantial portion of the company’s revenue relies on a single customer. The loss of a major revenue source can significantly impact the company’s valuation and may hint at underlying issues related to product quality or customer satisfaction, potentially escalating troubles.
• Detached Management Teams: When the management team doesn’t routinely scrutinize financial statements, it becomes easier for internal parties to manipulate revenue or expenses. This lack of oversight can signal to potential buyers that the ownership or management lacks control over the business, eroding trust in the company’s leadership.
• Ethical Breaches: Although less frequent, unethical conduct can be a significant problem – offering inducements like cash payments or off-the-books transactions. Such issues trigger buyer suspicion and may lead to concerns about hidden skeletons. In some cases, they can even derail a deal entirely. Warren Buffett’s famous quote, “You can’t make a good deal with a bad person,” resonates with many astute buyers who, upon discovering unethical behavior, often opt to terminate the transaction without further negotiation. Even if they decide to proceed, the buyer will likely require the owner’s continued involvement post-closing, making it improbable for an untrustworthy party to have a role in the company’s operations.

One major advantage of the QoE report is it enables the seller to identify and resolve any problems before going to market.

Buy-Side vs. Sell-Side QoE Report

Whether it’s initiated by the seller, referred to as a “sell-side QoE,” or by the buyer, known as a “buy-side QoE,” the quality of earnings report shares consistent content and purpose across both scenarios.

Who pays for the report?

Sell-Side

In the case of a sell-side QoE report, the seller covers the costs. This investment is often justified as it frequently leads to a higher valuation and a more seamless transaction process.

Buy-Side

When requested by the buyer, it’s typically the buyer who bears the expense. In some situations, especially with larger businesses that should have maintained consistent financial audits but haven’t, the buyer may negotiate for the seller to share part of the cost. However, it’s generally considered a conflict of interest for a firm to represent both the buyer and seller in such cases.

The Buy-Side QoE Report

The Buyer’s Objectives

For a buyer, the purpose of a QoE report is to instill confidence in their investment and validate the earnings upon which their offer is based. It offers a deeper understanding of account balances, cash flows, and the overall operations of the business.

Additional Insights

The report provides a comprehensive view of the business’s strength and the likelihood of sustained performance. It can be instrumental in securing financing or obtaining approvals from boards or investment committees. While a QoE report doesn’t replace the buyer’s financial due diligence, it serves as a vital, independent tool for comprehending the business.

Who Covers the Cost

Buyers may express concerns about the expense of a quality of earnings report. However, if the insights gained lead to a more favorable sale price or offer valuable insights for cost reduction post-acquisition, the investment can be justified.

The Sell-Side QoE Report

The Seller’s Objectives

For sellers, conducting a Quality of Earnings (QoE) analysis serves as a proactive approach to identify and resolve potential issues before entering the market. Every seller aims for a swift and smooth transaction without unexpected surprises. This analysis offers a fresh perspective, allowing you to view your business through the lens of potential buyers. By addressing issues early, it significantly enhances the chances of a successful closing, maximizes the business’s value, and expedites the overall timeline.

The Significance of an External Perspective

Entrepreneurs often possess an in-depth understanding of their businesses and are accustomed to the associated risks. However, familiarity can sometimes lead to overlooking critical aspects. Buyers may approach the industry from different angles or have unique organizational structures compared to the business they intend to acquire. Investors, such as private equity firms, might not be well-versed in the industry specifics. A QoE report introduces a fresh viewpoint that owners might otherwise miss.

Why Sell-Side QoE Reports Have Become Standard Practice

In recent years, sellers have adopted a proactive approach by commissioning QoE reports on their businesses before entering the market. This approach is akin to conducting a home inspection before selling a house. Obtaining a sell-side QoE report offers several advantages: it instills confidence in buyers, uncovers and addresses potential issues proactively, streamlines the transaction process, and demonstrates the seller’s commitment. Sell-side QoE reports are now considered standard practice, and not having one can put sellers at a disadvantage.

The Power of Preparation

If the report uncovers any unfavorable findings, sellers have the opportunity to rectify them before entering the market or, at the very least, to disclose them transparently to avoid surprises that could impact the purchase price. Sellers planning to sell in the near future can commission a QoE report well in advance, allowing ample time for issue resolution. When it’s time to go to market, a simple update of the report should be both cost-effective and beneficial.

Mitigating Risk

A Quality of Earnings (QoE) report serves as a critical tool for sellers to gain a candid perspective on their businesses before entering the market. It plays a pivotal role in identifying financial inconsistencies and areas of concern that require attention before initiating a sale. This strategic analysis provides precise guidance to management on optimizing the business’s value. By addressing these issues upfront, it effectively eliminates unwelcome surprises that could potentially diminish the final purchase price or even derail the entire transaction.

Impact on the Transaction

A reputable sell-side QoE report holds the potential to bolster the selling price. It can be leveraged in negotiations to secure more favorable terms, such as increased cash at closing and reduced contingent payments like earnouts. Moreover, it streamlines the due diligence process and may result in less stringent representations and warranties terms or lower premiums for warranties insurance.

Identifying Additional Adjustments

While both the seller’s and the buyer’s QoE teams may identify adjustments impacting adjusted EBITDA, it’s important to note that the buyer’s diligence team lacks the incentive to uncover add-backs that could raise EBITDA, potentially leading to a higher acquisition cost for their client. When sellers engage a QoE provider independently, the sell-side analyst is better positioned to uncover additional adjustments that positively impact the valuation – adjustments that a buy-side QoE report might overlook.

Timing

When the QoE report is requested by the buyer, it typically comes into play after the signing of a letter of intent (LOI) and the initiation of an exclusivity period during which due diligence takes place. It’s a pivotal step in the process, as most buyers understandably require an exclusive commitment from the seller before they invest the time and resources required for a comprehensive QoE report.

It’s best practice for sellers to perform their own QoE analysis even though the buyer will conduct financial due diligence.

Audit vs. QoE Report

A common misconception I often come across is the belief that a QoE report and audited financial statements are synonymous or serve identical purposes.

So, are an audit and a QoE report the same? If not, what sets them apart?

Audit

Audits are essentially a backward glance – they focus on historical balance sheets and ensure that financial statements adhere to generally accepted accounting principles (GAAP). They are an attest service, a formal evaluation of a company’s financial statements by a certified public accountant (CPA). Audits strictly follow established guidelines and processes. Additionally, audits are a mandatory requirement when certain conditions are met. It’s worth noting that audits must be conducted by a CPA and typically do not cover the two most recent interim periods.

QoE Report

On the other hand, a Quality of Earnings (QoE) report primarily looks forward – it centers on, as the name suggests, the quality of a company’s future earnings. It scrutinizes the income statement, prioritizing earnings, and is less concerned about strict GAAP compliance. A QoE report engages in various analytical procedures intended to gain a deeper understanding of a company’s risks in a potential acquisition. It evaluates the risk associated with future earnings. Unlike audits, a QoE report doesn’t require a CPA’s involvement, and it generally covers the three to five most recent fiscal years, including interim periods.

QoE reports stand out from audits in several ways because they:

• Consider add-backs and adjustments to financial statements, deviating from GAAP.
• Offer a more comprehensive understanding of typical operating conditions and financial performance.
• Analyze the potential impact of subjective factors like risk concentrations, industry dynamics, economic variables, and elements that may affect a business’s financial performance.
• Embrace both backward and forward-looking perspectives.
• Provide insights into a company’s current and future earning potential.
• Scrutinize operations to anticipate how the business might perform in the future.
• Are a consulting engagement rather than an attest service, granting flexibility in approach and scope.
• Lack a prescribed form or specific materiality threshold.
• Come in various formats – there’s no universally accepted QoE report format.
• Offer insights and perspectives often absent from audited financial statements.

Do I Need Both an Audit and a QoE Report?

Clients often inquire about the necessity of a Quality of Earnings (QoE) report if their financials have already undergone an audit. The straightforward answer is yes, and the reason lies in the fundamental distinction between an audit and a QoE report.

The primary objective of a QoE report is to facilitate M&A (Mergers and Acquisitions) transactions, whereas an audit’s primary purpose is to verify whether financial statements adhere to Generally Accepted Accounting Principles (GAAP) and provide an accurate representation of a company’s financial status.

When contemplating the sale of your company, a QoE report offers more value than an audit and positions you favorably to secure the best deal possible. CPAs experienced in conducting QoE analyses possess invaluable insights into what prospective buyers seek in M&A deals. Consequently, they can efficiently identify and address any financial statement issues that need resolution before entering the market.

It’s worth noting that even if the buyer intends to commission a buy-side QoE analysis, it remains prudent for the seller to conduct their QoE analysis. This point cannot be stressed enough: Sellers should undertake their QoE analysis, even when buyers plan to perform financial due diligence and engage their QoE firm.

The Quality of Earnings Analysis Process

Scope

The scope of each Quality of Earnings (QoE) report, and consequently the process involved in its preparation, is subject to variation based on factors such as the company’s size, the specific transaction, and the level of confidence the buyer seeks during the due diligence phase. Below is a general overview of the process.

Gather Information

The inaugural step in the creation of any QoE report entails the collection and meticulous organization of essential data for analysis.

Key sources of information encompass:

• Historical financial statements (including income statements, balance sheets, and cash flow statements) for the preceding three to five years, encompassing monthly trial balances.
• Current (interim) financial statements.
• If available, forecasted financial data.
• Copies of any existing loan or debt agreements.
• Federal, state, and local tax returns spanning the past three to five years.
• Bank statements.
• Federal income tax returns.
• Management interviews.

In most cases, especially for smaller businesses, the CFO, controller, and owner are typically responsible for furnishing the necessary accounting and financial information to the entity preparing the QoE report. This process may involve supplying background details about the company, offering insights into financial trends, and responding to any queries posed by the analyst.

Preliminary Analysis and Discussion

Preliminary Analysis

Following the meticulous gathering and organization of information, the analyst may commence with a preliminary analysis. In certain scenarios, particularly with long-established companies, obtaining data might require creative methods due to outdated systems or limitations. System constraints could sometimes hinder access to critical data, preventing a comprehensive analysis. For instance, the analyst might seek to examine gross margin trends by product line, but the company’s systems may not track margins in such detail. Another common challenge arises when costs are inadequately attributed. Conducting a preliminary analysis provides an initial framework for the Quality of Earnings (QoE) report.

Discussion

Should discrepancies or inconsistencies arise during the analysis, it becomes imperative to engage in discussions with the seller’s management team. While evaluating the data, the analyst adopts the perspective of a potential buyer to comprehend their objectives fully. Often, this involves revisiting questions multiple times to delve deeper into the issue, peeling back layers like an onion to uncover the core of the matter.

Resolving Conflicting Information

Occasionally, the analyst may encounter conflicting information from various sources within the organization, such as the in-house bookkeeper, accountant, owner, and management team. These stakeholders might offer differing responses to similar questions, sometimes influenced by their perception of what the analyst wishes to hear. In such cases, it’s through persistent and targeted probing questions that the analyst can truly grasp the issue and address it effectively within the report.

The QoE report is sometimes the primary component of a larger financial due diligence analysis.

Adjustments to the Financial Statements

The subsequent phase involves the meticulous elimination of all non-recurring revenue and expenses, ensuring that the financial statements exclusively mirror the fundamental business activities.

Examples of Non-Recurring Income Comprise:

• Gains on the Sale of Assets
• Insurance Claim Awards, Litigation Rewards, or Workers’ Compensation Refunds
• Unprecedented, One-time Revenue Projects or Contracts
• Paycheck Protection Program (PPP) Loan Forgiveness
• Employee Retention Credits (ERC)
• Economic Injury Disaster Loan (EIDL) Forgiveness
• Bank Debt Forgiveness

Examples of Non-Recurring Expenses Include:

• Inclusion of Family Members on the Payroll Who Aren’t Engaged in the Business
• Incorporation of Owners’ Personal Expenses or Perks Into Business Expenditures
• Expenses Linked to Non-Recurring Revenue
• Litigation Fees and/or Losses
• Losses Arising from Asset Sales
• Losses Related to Discontinued Operations
• Losses Stemming from Natural Disasters

One of the primary objectives underlying a Quality of Earnings (QoE) report is the comprehensive understanding of the core business’s performance. The meticulous removal of non-recurring income and expenses constitutes a pivotal phase in this process, allowing the report’s readers to delve into a thorough analysis of the fundamental business operations.

Detailed Analysis

Once the financial information has been meticulously gathered, scrutinized, and the financial statements adjusted accordingly, the next phase involves a comprehensive exploration of the business’s operations. This deep dive is essential for providing the buyer with the most informed and insightful perspective on the business.

The detailed analysis may encompass a thorough evaluation of the following key aspects:

• Age of Equipment
• Workforce Demographics
• Customer Concentration
• Employee Compensation
• Employee Retention Rates
• Inventory Management Efficiency
• Key Employee Concerns or Risks
• Trend Analysis Over Monthly and Yearly Periods
• Potential Capital Expenditure (CapEx) Requirements
• Profit Margins, Segment-wise (Customer, Product, or Service)
• Vendor Concentration

This level of analysis goes beyond the surface, uncovering critical issues and insights that may remain hidden during an initial review of the financial statements. A well-prepared Quality of Earnings (QoE) report should not only encompass quantitative data but also offer valuable commentary and expert opinions on each area examined. It’s this comprehensive analysis and insightful commentary that distinguish an excellently crafted QoE report from a less comprehensive one.

Finished Product

QoE Report vs. Financial Due Diligence: Unveiling the Distinctions

A Quality of Earnings (QoE) report is a vital component within the broader spectrum of financial due diligence. It serves as a key element, often taking center stage, in a comprehensive analysis that aims to shed light on a company’s capacity to generate future cash flows based on its historical performance.

The Structure

Unlike audits, there exists no standardized format or prescribed content for a QoE report. Nevertheless, the final output typically materializes in the form of a PDF document or an intricate spreadsheet. In the case of a spreadsheet, it can encompass numerous tabs, guiding the reader through a meticulous journey from the initial financial statements to the adjusted EBITDA.

In-Depth Insights

Within the QoE report, you can expect to find a wealth of information. This includes substantiation of revenue and cash, reconciliation bridging the gap between financial statements and bank records, detailed projections, and much more. Each facet receives meticulous attention, delving deep into the numerical intricacies. The report doesn’t merely present the numbers; it provides clear explanations and discerns the implications of its findings in each specific area examined. This depth of insight sets a well-crafted QoE report apart, ensuring it serves as a valuable tool for informed decision-making in the financial landscape.

Stakeholders

Given the significance of investments, it’s essential to provide assurance to various stakeholders regarding the soundness of the decision and the reliability of the target company’s financials. Both the Quality of Earnings (QoE) report and the financial due diligence report play pivotal roles in this process.

The QoE report often extends its reach beyond the immediate parties involved in the transaction. It may be shared with a range of stakeholders, including lenders, private equity investment committees, insurance firms, and key related parties. Private equity investors, in particular, tend to demand these reports. They do so not only to conduct their independent analysis but also to gain an additional perspective on the transaction that might otherwise elude them.

Furthermore, requests for these reports are commonplace, coming from boards of directors at strategic buyers or public companies, as well as from investment committees within private equity firms. The aim is to ensure a comprehensive and well-informed evaluation of the investment opportunity.

Timing

Quality of Earnings (QoE) studies usually span a timeframe of approximately 30 to 45 days. However, the actual duration hinges on the promptness with which the owner or management team provides necessary information and addresses inquiries. Coordinating the QoE report alongside the investment banker’s activities can often help preempt any delays that might occur after the Letter of Intent (LOI) is in place.

Hiring a QoE Provider

The Importance of Experience

• Firm Types: Typically, QoE studies are carried out by CPA firms and specialized financial due diligence firms.
• Reputation Matters: Opt for a firm renowned for its commitment to quality and its capacity to meet the rigorous demands of private equity or strategic buyer financial due diligence.
• M&A Expertise: Ensure the team you engage possesses extensive experience in conducting financial due diligence for M&A transactions, ideally within your specific industry.
• Independence: Importantly, the firm responsible for your QoE report should be distinct from the one responsible for your financial statements. This separation ensures impartiality and objectivity in the analysis.

How Much Does a QoE Report Cost?

Pricing Spectrum

Quality of Earnings (QoE) studies can span a wide pricing spectrum, catering to the unique needs and complexities of different businesses. The cost can vary significantly, ranging from as low as $5,000 for a basic report suited to a small company, to exceeding $100,000 for an extensive analysis tailored to a mid-sized firm.

• For Small Companies: If your company boasts revenue below $10 million and operates with relatively straightforward financials, you can typically secure a comprehensive QoE report for an investment of approximately $10,000 to $20,000. Local firms often suffice for this category.
• For Mid-Sized Companies: On the other hand, if your business generates revenue beyond the $10 million mark, it’s advisable to consider a regional firm. This not only enhances the report’s credibility but also aligns with the expectations of private equity firms, particularly for businesses with revenue ranging from $10 million to $25 million.

Varied Cost Factors

Several factors contribute to the cost and timeline of a QoE report, including:

• Business Size: Larger businesses tend to involve more comprehensive analyses and thus may command higher costs.
• GAAP Adherence: The degree to which financials adhere to Generally Accepted Accounting Principles (GAAP) can impact the complexity and cost of the report.
• Financial Cleanliness: The clarity and accuracy of financial statements can influence the scope of work required.
• Business Complexity: Factors like inventory management and the number of entities involved can add complexity to the analysis.
• Industry: Different industries may necessitate specialized expertise, affecting the overall cost.
• Choice of Firm: The selection of a small to mid-sized firm optimized for the middle market often results in favorable pricing compared to larger accounting firms offering equivalent services.