In the intricate realm of merger and acquisition (M&A) transactions, the spotlight falls squarely on the importance of Quality of Earnings (QofE) due diligence, particularly from the seller’s perspective. It represents a critical juncture where the buyer’s independent accountants verify the company’s overall financial performance, with significant stakes riding on the findings.
Quality of Earnings typically starts after an LOI (Letter of Intent) has been signed as one of the first steps in Due Diligence. Your advisors will play key roles during Due Diligence and QofE. Your advisor team will typically include your M&A Broker or Business Broker, CPA, and attorney.
The QofE findings serve as the ultimate evaluation of the company’s EBITDA, revenue, and overall financial well-being. These factors either bolster the business value outlined in the LOI or purchase agreement or necessitate a price adjustment if they fall short. Therefore, the outcome of the QofE assessment is a crucial milestone in the transaction, impacting both the buyer and the seller significantly.
In this blog post, we’ll explore QofE due diligence through the seller’s lens, highlighting its significance, key considerations, risks, and the strategic advantages in obtaining a seller’s QofE to maximize value and defend the business value.
The Significance of Quality of Earnings Due Diligence for Sellers
Quality of Earnings due diligence is not just a routine step in the M&A process; it’s a pivotal point after an LOI has been accepted and Due Diligence has commenced. At this stage, all parties are eager to finalize the deal, and a successful QofE, substantiating the financials outlined in the CIM (Confidential Information Memorandum) presented to the Buyers, becomes an essential next step for everyone involved.
For privately held mid-size and lower-middle market companies, QofE assumes particular significance during Due Diligence for a transaction (sale). Typically, such companies do not have Reviewed or Audited Financial Statements prepared by their CPA. Instead, they often choose to have their CPA compile their annual tax return without conducting a formal review of internal P&Ls, Balance Sheets, and other financial statements to minimize accounting fees. As these financial statements are solely for internal use, there’s typically no immediate need to incur additional expenses. This underscores the heightened importance of QofE for prospective buyers in such scenarios.
For Private Equity firms and industry buyers, QofE becomes a necessity due to their investor base, stockholders, or public trading status, all of which mandate a Quality of Earnings report for acquisitions.
Key Considerations about QofE from the Seller’s Perspective
Below are key points in a Quality of Earnings review and some of the common challenges.
- Transparent and Accurate Financial Reporting following GAAP:
Sellers must ensure transparent and accurate financial reporting to instill confidence in potential buyers or investors. This involves meticulous documentation of revenue recognition practices, expense breakdowns, and cash flow management to provide a clear picture of the company’s earnings quality.
It is important to note that a Quality of Earnings review will be according to GAAP (Generally Accepted Accounting Principles). If your company financial statements do not conform to GAAP, the accounting firm will make any needed adjustments to conform to GAAP. - Proactive Issue Identification and Resolution:
Anticipating potential issues or discrepancies in financial statements and proactively addressing them can strengthen the seller’s position during negotiations. By conducting internal quality of earnings assessments prior to engaging with buyers or investors, sellers can identify areas for improvement and take corrective actions to enhance earnings quality. - Accrual vs Cash Basis Adjustments
In performing a Quality of Earnings review and report the independent accounting firm will review the company’s financial statements to ensure they conform to GAAP (Generally Accepted Accounting Principles). If the business tax returns and financial statements are prepared on a Cash Basis, they will be converted to Accrual Basis during QofE as this is the GAAP standard. - Owner’s Benefits & Expenses
Owner’s benefits and expenses are added back in the calculation of Discretionary Earnings (DE) and normalized EBITDA. During a QofE review, documentation will be required for these expenses and some may be disallowed which reduces the company earnings accordingly.
Notably, owner’s expenses within Cost of Goods Sold (COGS) typically face resistance as add-backs and are advised against. - Inventory:
Inventory adjustments are common during QofE. Inventory value on a company’s balance sheet is rarely an accurate reflection of the actual inventory value. Inventory adjustments will affect the company’s balance sheet and P&L/earnings.
Inventory deemed obsolete or slow-moving will be written off to zero value. Under US GAAP, inventories are measured at the lower of cost, market value, or net realizable value depending upon the inventory method used. Market value is defined as current replacement cost subject to an upper limit of net realizable value and a lower limit of net realizable value less a normal profit margin. - WIP:
Work In Progress is another area that commonly has adjustments during QofE. The adjustments will depend on which accounting method the company is using. During QofE the goal is to determine an accurate cost for the WIP. - Working Capital:
Quality of Earnings will calculate the working capital required for the business. Some LOIs-Purchase Agreements include working capital in the offer. Consequently, the working capital calculation is an important one. - Deferred Income or Expenses:
Deferred income pushed into the next tax year is reviewed and may be adjusted into the proper period. Likewise, deferred or accelerated expenses are adjusted to match the proper accounting period. The objective is to properly account for revenue and expenses in the correct accounting and tax period. - Client Concentration and Churn:
Client concentration can be a concern for buyers if there are customers that represent more than 30% of annual sales. Likewise, if there is a high churn rate (customer turnover) this may be a concern in some industries. Note that in some industries that are project based customer churn is normal, e.g. construction landscaping, etc. - Employee Retention:
Employee tenure and experience is important to prospective buyers to ensure continuity in business operations. This does not have a direct affect on the QofE results or valuation, but high turnover would create concern. - Effective Communication with Buyers or Investors:
Open and transparent communication with potential buyers or investors is essential throughout the due diligence process. Sellers should be prepared to address inquiries promptly, provide supporting documentation, and clarify any concerns raised regarding the company’s financial performance and outlook. - Availability and Accessiblity to Financial Records and Company Data
The buyer’s QofE accounting firm will have a comprehensive list of Due Diligence information required to complete the review. Availability of data is often the pacing item during QofE and the most likely thing to cause delays.
To keep your QofE review on track and on time, make sure all of your financials are available and can be uploaded easily and quickly to an electronic data room.
Strategic Advantages of Sellers Preparing Their Own QofE
In some instances, a seller may opt to engage an independent accounting firm to prepare their own Quality of Earnings Report in advance of putting the business on the market. While this investment can be significant, often starting at $25,000, the advantages of obtaining a QofE report are considerable. Gulf Coast Financial (GCF) offers two QofE reports well suited for mid-size business owners who want to obtain their own QofE before taking their business to market.
- Anticipating and Eliminating Surprises:
By engaging an independent accounting firm to conduct a Quality of Earnings analysis, sellers can ensure the accuracy of their financial statements and preempt any unexpected findings that may arise during the buyer’s due diligence process. The Seller and broker can present revenue and earnings figures with confidence the figures are accurate and will stand up to a thorough review during diligence. - Maximizing Valuation:
Equipped with a comprehensive Quality of Earnings report, sellers and their brokers possess validated revenue and EBITDA figures to present to potential buyers with a high level of confidence. This allows for clear communication in confidential information memorandums (CIMs), indicating that an independent QofE has been undertaken, and that the financial metrics provided are derived from this analysis. By showcasing validated, sustainable revenue streams, efficient cost management, and growth potential, sellers can command a higher purchase price or investment valuation. - Reducing Transaction Risks:
Proactive due diligence from the seller’s perspective aids in identifying and addressing potential risks that could impede the transaction process. By proactively tackling any financial discrepancies or operational hurdles upfront, sellers can foster trust and confidence in prospective buyers or investors, thereby expediting the deal closure process. - Enhancing Negotiation Leverage:
Armed with a thorough understanding of their company’s earnings quality and growth prospects, sellers gain leverage during negotiations with potential buyers or investors. This allows sellers to negotiate favorable terms, including purchase price adjustments, earn-out provisions, or indemnification clauses, while safeguarding their interests. - Facilitating Smooth Transaction Execution:
Quality of earnings due diligence lays a solid foundation for efficient transaction execution. By furnishing buyers or investors with transparent and reliable financial insights, sellers can streamline due diligence efforts, mitigate deal-related delays, and facilitate a seamless transition to post-closing integration activities.
Conclusion
The significance of Quality of Earnings (QofE) due diligence for sellers in M&A transactions cannot be overstated. As a pivotal point in the process following the acceptance of a Letter of Intent (LOI) and commencement of Due Diligence, QofE serves as a critical step toward finalizing a deal successfully. Particularly for privately held mid-size and lower-middle market companies lacking Reviewed or Audited Financial Statements, QofE assumes heightened importance, offering prospective buyers transparency and confidence in the company’s financial performance.
From the seller’s perspective, proactive engagement in QofE brings several strategic advantages. Transparent and accurate financial reporting in accordance with GAAP instills confidence in potential buyers or investors. Proactively identifying and resolving issues strengthens the seller’s position during negotiations. Moreover, preparing for QofE can anticipate and eliminate surprises, maximize valuation, reduce transaction risks, enhance negotiation leverage, and facilitate smooth transaction execution.
By investing in an independent QofE analysis, sellers can present validated financial figures with confidence, attracting potential buyers with reliable revenue streams and growth potential. This not only expedites the deal closure process but also ensures a seamless transition into post-closing integration activities. Ultimately, QofE due diligence serves as a cornerstone for building trust, mitigating risks, and unlocking value in M&A transactions, benefiting both sellers and buyers alike.
