Quality of Earnings Reports
What are they and what is their significance?
Quality of Earnings Defined
A quality of earnings (“QoE”) report is a common financial diligence item utilized by both buyers and sellers in private business transactions. The report is generally performed by a credible independent third-party accounting firm and is used by buyers to substantiate revenues, expenses, “adjusted” earnings, and “normalized” working capital – all of which are key financial measures used to either confirm or determine the ongoing value of the business.
QoE vs Audit
A traditional financial audit done by an accounting firm is concerned with creating financial statements and related footnotes to accurately portray the performance of the business based on generally accepted accounting principles (“GAAP”). Audits also often include a review of financial controls and reporting standards. The QoE, by contrast, also adjusts to GAAP, but provides an analysis of one-time and non- recurring items to identify a target company’s trailing twelve months earnings profile (“TTM EBITDA”). A QoE will also usually address other transaction-related items such as owner adjustments and an analysis of net working capital.
QoE Summary
-
Cost varies depending on scope of project, but a typical range is $25k - $75K
-
2-4 weeks, typically requiring 1-2 days on-site for in-depth financial review
-
Potentially significant (see case studies below)
-
Can protect or create $millions in value for both buyers and sellers
The Importance of the Quality of Earnings
The QoE report is primarily used to provide buyers an independent view of the true earnings profile of a business. Oftentimes buyers will use the report to either confirm or object to the seller’s internally prepared financials, which ultimately impacts the negotiated purchase price between buyer and seller. Without the report it can be difficult for a buyer to fully understand the nuances of the business and its associated financial performance.
-
Small- and medium-sized businesses typically have internally prepared financials and don’t always conform with GAAP. Part of the QoE objective is to take the internally prepared financials and report them under GAAP guidelines. Depending on the sophistication of a business’s accounting processes, this can result in significant variances, both positive and negative. Buyers and sellers, alike, should have interest in the QoE’s results, as it ultimately substantiates the basis for the company’s value.
-
Often the purchase price for a transaction is based on a multiple of EBITDA, which is a point of analysis and negotiation throughout a transaction. Sellers will include various “adjustments” to EBITDA in order to increase the total purchase price. These adjustments include various one- time, irregular, and non-recurring expenses. Other adjustments, such as pro forma adjustments, take into consideration recent trends in the business. The QoE focuses on a wholistic earnings view to reach a defendable “Adjusted EBITDA”.
-
Other key transaction data points that a QoE will analyze:
Net Working Capital (NWC): NWC is current assets minus current liabilities. This figure demonstrates the amount of “normalized” working capital needed to fund operations.
Operational Risks: Analysis of a business’s exposure to certain risk categories such as customer or geographic concentrations, supply chains, commodities, end markets, regulatory exposure, leadership, and more.
Who Orders & Pays for the QoE?
An important concept from the seller’s perspective, as it is a balance of cost, risk, and negotiating position
Buyside
Historically, the “buyside” (buyers / acquirers) require a QoE to be performed after they are under letter of intent (“LOI”). The buyside pays for this report in conjunction with other diligence streams being conducted on their behalf. Although the seller doesn’t “pay” for this, there are a number of reasons why it matters:
• Lack of EBITDA clarity: Often the LOI outlines or assumes a multiple of EBITDA for the purchase price. As such, the final independent figure is unknown until this report is concluded. Generally speaking, the side that orders the QoE is in a better negotiating position.
• Disadvantaged negotiation position: Sellers who don’t obtain their own QoE run the risk of not having an independent “expert” to back up their negotiating position. Buyers are able to lean on the experts, which can make it very difficult for sellers to effectively negotiate any findings in the QoE.
Sellside
It is becoming increasingly common for the “sellside” (the company looking to sell or receive capital) to order a QoE prior to taking the company to market. Although the seller has to pay for this report, there are clear advantages:
• EBITDA clarity: Sellers can obtain significantly more clarity into the financial performance buyers will ultimately pay for in a competitive process. It greatly improves a seller’s probability of closing a transaction after an LOI.
• Harder to get “negotiated”: A tactic sometimes deployed by buyers is to use the QoE findings as a basis to “retrade” terms that have been agreed to in the LOI. Buyers may still order their own QoE, but disagreements of methodologies and results will be amongst accountants and thus harder for a buyer to use as a basis for a retrade.
Case Studies
Industrial Services Business
Sellside QoE
Historical reported EBITDA was $5.0MM
Buyside QoE reported numerous deficiencies in costing methodologies
Buyer only wanted to pay based on QoE adjusted EBITDA of $4.0MM
Deal fell apart after the LOI had been executed
Manufacturing Business
Sellside QoE
Historical reported EBITDA was $4.0MM
Company was growing substantially with term contracts
Buyside QoE identified numerous expense adjustments to historical EBITDA
Sellers successfully defended purchase price based on growth profile and market position
Healthcare Services Business
Sellside QoE
Historical reported EBITDA was $2.5MM
Sellside QoE report identified growth trends and substantiated a $3.5MM proforma EBITDA
Buyside QoE provider argued expensing methodologies but ultimately lost argument
Buyer paid based on sellside QoE proforma adjusted EBITDA
Distribution Company
Sellside QoE
Historical reported EBITDA was $2.2MM
Overcosted cost of goods sold & understated inventory
Sellside QoE adjusted EBITDA to $3.5MM on a proforma basis
Buyside QoE provider also calculated adjusted EBITA at $3.5MM > Deal reached
