Quality of Earnings Report – Why you will want one of these!

You may initially think this is going to be a “yawn” post, but oh, so not true!

Listen up, if you are really serious about selling your company for the highest price, then you really need to understand what a Quality of Earnings Report is (also known as Q of E) and why you may want to pay for it and not have the buyer do it (see my ah ha moment below).

What is a Quality of Earnings Report?

These reports are frequently prepared by independent third-party firms during due diligence in an acquisition. The reports are often requested by a board of directors of a strategic buyer or an investment committee of a private equity buyer. Net income is not necessarily a 100% accurate indication of a company’s financial performance. If a company reports large net income figures but negative operating cash flow, for example, then it may not be as financially sound as it appears.

The primary objective of a quality of earnings report is to assess the sustainability and accuracy of historical earnings as well as the achievability of future projections. Unlike an audit, where the emphasis is on the   balance sheet, a Q of E is designed to provide a professional, third-party analysis of three things:

Who Needs a Q of E?

My advice is that any company over $5M in revenue who has a component of deferred revenue, (albeit subscription generated or otherwise) should consider investing in this report. Also, anyone who has an unusual amount of EBITDA adjustments, so that these can be validated by a third party. And now anyone who might have unusual adjustments to income due to COVID.

I believe so heavily in the validity of this report, that I now make it mandatory for any of my clients over $10M in revenue to get one completed as it drastically speeds up due-diligence and adds to the value of the company overall. More on this below.

What Does a  Q of E Cost?

Depending on the deal and the audience of potential investors or buyers, quality of earnings studies cost between $20,000 and $80,000. If your jaw just dropped, keep in mind that they are typically on the lower end of that spectrum and as you read on you will see that this investment will pay for itself.

The size of your company should really dictate who you use to produce the report which will impact the cost of the report. Meaning, you can probably spend as little as $20K for a local firm to produce the report, which is probably fine for anyone below $10M in revenue and who’s revenue is not overly complicated. If you have over $15M in revenue, I suggest stepping up to a more regional firm, just so it has a bit more gravity. Private equity firms typically like to see well known regional firms prepare these for firms under $100M in revenue.

Who Provides the Q of E?

Q of E studies are conducted by CPA firms and specialized financial due diligence firms. It is important to use a firm that carries a reputation for quality and has the ability to withstand the rigors of private equity or strategic buyer financial due diligence.

What Are the Benefits?

While your M&A advisor or investment banker can do most of this, an independent look, adds validity to the process. Here are the four main benefits of a quality of earnings study:

1. Help Avoid Future Price Renegotiations/Retrading

• Increase the likelihood of closing. Q of E firms present your financials the way buyers think about them. This process helps eliminate misunderstandings or miscommunications related to accounting interpretations. Everyone will be on the same page in terms of accounting policies, accrual vs cash, etc.
• Uncover one-time, non-recurring add-backs or cost eliminations that you should get credit for. Because of the detailed nature of these studies, and the fact that you have another professional in addition to your advisor analyzing the seller, it is not uncommon to identify add-backs for the Q of E firm to validate and the advisor/investment banker to advocate for its client.
• Most private equity buyers use debt to fund transactions (in whole or in part), which drives purchase price. Lenders usually will not issue final term sheets without the sellers conducting Q of E studies; therefore, having one done early helps ensure that valuations presented in letters of intent are more precise and accurate.
• Defend or position large add-backs because they are validated by a third-party professional. Again, with new adjustments due to COVID, (see my recent post linked above), it is especially important to have these one-time adjustments discovered and validated.

• Finally, and maybe most importantly, the report truly determines your revenue on an accrual basis. So many companies (regardless of size) don’t follow true GAAP. There always seems to be something that follows cash basis accounting, because, well its just easier. This report will now provide a better indication of your income and expenses on a true GAAP basis. Frankly, this alone can kill a deal.

2. Shorten the Deal Timeline

• Many buyers will not engage their legal counsel to draft closing documents until the Q of E is complete because of the risk of uncovering something important that may jeopardize the deal.
• Many of the documents needed for due diligence are also needed for the Q of E. This will give you a leg up on getting all of these accumulated into a virtual data room in advance. Trust me, this in itself is worth getting the report completed in advance of going out to market.
• Q of E studies typically take around 30 days. Completing this concurrently with your investment banker’s process may eliminate altogether post-LOI delay.
• The expression “time kills all deals” is so true in M&A deals. Every day that a deal is under letter of intent is another day something could change in your business.

3. Positioning

• Your M&A advisor/investment banker is telling your story, and potential buyers devote resources (both money and time) to determine whether they believe that story. If your deal comes with third-party validation of the numbers, potential buyers are more likely to believe your story and pursue your business.
• A Q of E packages your company nicely and reflects how this is going to be a great investment for the investor. Great opportunity for investors means stronger valuations.

4. Your Commitment to the Process

• Spending the time and effort to have a Q of E done prior to going to market tells all investors that you are serious about this process of selling your company. Prospective buyers do not want to put in a ton of effort to have you decide at the end, you don’t want to sell. Of course, committing to a Q of E report doesn’t completely mitigate that, but it does tell investors you are serious about selling your company as it requires a lot of time, effort and money to have a report completed.

Why a Q of E and Not an Audit or Review

In general, an audit/review report provides assurance that your company’s financial statements are not materially misstated. A Q of E financial due diligence performs analytical procedures to gain a deeper understanding of the economic risks of a company in the context of an eminent M&A transaction. One really focuses on the balance sheet, while the other focuses more on revenue and margins. Here is a quick chart to distinguish the two:

The Ah Ha Moment

Finally, what I am sharing with you next, you will not find anywhere else, and unless you go through the process of having both the buyer and seller produce/work on the same Q of E, you really cannot see this firsthand or experience it.

Let me give you an example:  In a recent transaction, a buyer who was very interested in my client engaged a firm to provide a quality of earnings report. The Q of E was completed while my seller finalized due-diligence items and finalized all redlines of the agreements. Due to COVID, the buyer backed out of the transaction two weeks before the close. The Q of E had been prepared for the three preceding calendar years.

Fortunately, we had two other buyers willing to step in with a new LOI, but enough time had gone by that we had now completed another quarter of transactions (Q1 2020) and we wanted an updated report to reflect the increase in revenue. We engaged with the CPA firm (with the consent of the initial buyer) to extend the reporting period another quarter for an additional fee. Since we were now the ones paying for the report, it was now a Sell Side report which allowed us the opportunity to highlight areas that we felt were important and that they buyer initially did not. For example: the firm uncovered more EBITDA adjustments (in our favor) and we were able to better articulate the importance of the top 20 customers, not just the top 10. Did the numbers change, of course not, but the report took a slightly different tone and accentuated the positive aspects of the seller.  Basically, the same report with a different spin! 

This became my ah ha moment as I now realized that if the seller paid for the report, it could be presented in the seller’s favor!

One Last Tip

Ok, if you are this far in the post, you are probably serious, so let me give you one more tip. When you are interviewing firms to prepare this report, there are probably multiple versions you can buy, a light version a or heavier version depending on how detailed you want this to be. (Meaning: primarily that the narrative is reduced to the adjustments themselves instead of explanation for all causes of the fluctuations, changes in revenue, margin, etc.)  Should the buyer want to do more analysis, below are a list of items that are likely “buy-up” options:

• Full narrative report
• Cash proof agreeing bank statement receipts and disbursements to revenue and expenses, respectively.
• Budget to actual analysis (quality of budgeting) – helpful if trying to trade off projected earnings
• Free cash flow bridge
• Synergies analysis

A serious buyer won’t have a problem spending some money to get these additional items or you can split the cost with them. Just a thought.

Conclusion

Unless you are a smaller company (i.e., under $5M in revenue and $750K in EBITDA), I highly recommend you consider investing in a Q of E. The report provides accurate, high-quality position to your company which helps buyers recognize the hidden value of your company and its value proposition in the marketplace. While these reports can be fairly pricey, this is not a time to be penny wise and pound foolish,  as just one or two EBITDA adjustments that might otherwise be missed could well pay for if not add 100’s of thousands or even millions to your transaction value.

I didn’t do this for the sale of my previous company, and wish I had. Big mistake on my part, as I am sure I would have sold for more if I had.