Quality of Earnings in M&A – The Ultimate Guide

by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

Definitions

• Quality of Earnings Report: A third-party analysis of the selling company’s financial records prepared by an independent professional. The report verifies stated EBITDA, examines projected financial performance, and assesses to what extent revenue and earnings are sustainable. Other areas that are examined include quality of the assets, net working capital, accounting policies, debt and debt-like items, proof of cash and revenue, financial controls and reporting, quality of the supply chain, and adequacy of the management team.
• The Quality of Earnings Team: This is a third party retained to prepare the QoE report. The team is independent and has no stake in the game, so they are generally unbiased and not influenced by any pressure to do a deal.

Types of QoE Reports: Buy Side vs. Sell Side

There are two types of QoE reports. Generally, the contents are the same.

1. Buy Side: The buy-side report is requested by the buyer, who usually pays.
2. Sell Side: The sell-side report is requested by the seller, who always pays.
   Audit vs. QoE Analysis

An audit and QoE analysis aren’t the same:

• QoE: The main purpose of a QoE analysis is to facilitate an M&A transaction. CPAs who perform QoE analyses know what buyers look for and can identify issues that must be resolved before going to market.
• Audit: The main purpose of an audit is to confirm whether the financials comply with generally accepted accounting principles (GAAP).

How a QoE Report Fits Into the M&A Process

1. Negotiations
2. Letter of Intent
3. Start of Due Diligence — Quality of Earnings Analysis – Most buyers, as part of their financial due diligence (FDD) process, retain an independent third party to conduct a QoE analysis to validate the cash flow (i.e., EBITDA) the target business generates. The QoE is prepared after the letter of intent (LOI) is signed, and the parties have entered into an exclusivity period and are performing due diligence.
4. Conclusion of Due Diligence
5. Closing
6. Transition and Integration

Advantages of the QoE Analysis

Here’s a summary of the main purposes and advantages of a QoE analysis:

Advantages of the QoE – for the Seller

• Identifies additional EBITDA adjustments
• Improves negotiating leverage
• Identifies problems that can be resolved before going to market
• Serves as a trial run for due diligence
• Supports a higher purchase price
• Establishes an advantageous net working capital target
• Helps organize documents in advance for due diligence
• Demonstrates commitment to buyers
• Increases buyer confidence and interest

Advantages of the QoE – for the Buyer

• Provides a post-closing roadmap of issues that need to be resolved
• Helps estimate the amount of bank financing that may be available
• Ensures proper diligence

Advantages of the QoE – for Both Parties

• Facilitates a greater understanding of the business
• Increases the likelihood of closing
• Verifies EBITDA by a third-party expert
• Serves as a reliable basis for forecasts
• Offers an independent, objective perspective
• Minimizes the risk of post-closing working capital disputes
• Shortens the deal timeline

The Parties’ Objectives

Sell-side QoE reports are becoming standard for all but the smallest transactions, so not having one puts you at a disadvantage. QoE reports are now standard practice for all public and private equity buyers for transactions above a certain size. Obtaining a sell-side QoE report gives buyers confidence in your business, uncovers issues before they become problems, speeds up the transaction process, and is a strong signal to buyers that you’re serious. It’s best practice for sellers to arrange their own QoE analysis even though the buyer will conduct financial due diligence and retain their own firm to prepare a QoE report.

The following are the primary objectives of a sell-side QoE report:

• Improves the likelihood of a successful close and accelerates the timeline by allowing issues to be addressed early on
• Allows sellers to get an honest look at their businesses before entering the market
• Identifies inconsistencies in financials and areas of concern to address before selling
• Puts sellers in a strong position to discuss and explain issues to potential buyers
• Eliminates surprises that can reduce the purchase price or kill the transaction
• Helps support a higher price, a smoother process, and less stringent terms
• Uncovers additional adjustments that can increase the valuation

The following are the primary objectives of a buy-side QoE report:

• Validates earnings (EBITDA)
• Facilitates understanding of account balances, cash flows, and other accounting issues
• Gives a clearer picture of the general operations of the business
• Helps obtain financing or approval from board or investment committees

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

The QoE Analysis Process

Step 1: Gather Information

• Collect and organize the information needed to perform the analysis. Main sources of information include:
  • Historical financial statements
  • Interim financial statements
  • Forecast financial information
  • Tax returns
  • Bank statements
  • Management interviews

Step 2: Preliminary Analysis and Discussion

• Issues are discussed with the management team.

Step 3: Adjustments to the Financial Statements

• Non-recurring revenue and expenses are removed so the financials reflect only the core business activities.

Step 4: Detailed Analysis

• The strengths and weaknesses of the business are examined to help the buyer make the most informed decision possible and may include an examination of the following:
  • Age of equipment
  • Age of the workforce
  • Customer concentration
  • Employee compensation
  • Employee turnover
  • Inventory turnover
  • Key employee issues or risks
  • Monthly and yearly trend analysis
  • Potential capital expenditure (CapEx) needs
  • Profit margin by customer, product, or service
  • Vendor concentration
• A well-prepared QoE report will include observations on each area examined in the analysis.

Step 5: Finished Product

• While there’s no standard format, the finished product is usually a PDF file or spreadsheet.
• The report is the primary component of a larger financial due diligence analysis, providing a clearer view of a company’s ability to generate future cash flows based on past results.

Scope, Timing, and Stakeholders

• Scope: Depends on the concerns of the buyer and the complexity of the business.
• Timing: 30 to 45 days, depending on how quickly the owner or management team can supply the information and respond to questions.
• Other Stakeholders: The QoE report and financial due diligence will be shared with other stakeholders, such as lenders, private equity investment committees, and boards of strategic buyers or public firms.

Tips for Hiring a QoE Provider

• Type of Firm: QoE studies are usually conducted by CPA firms and specialized financial due diligence firms.
• Experience: Pick a firm that has a dedicated person or department focused exclusively on QoE services. The team should have extensive background conducting financial due diligence processes in M&A transactions and, ideally, in your industry.
• Reputation: Use a reputable firm with the ability to withstand the rigors of private equity or strategic buyer financial due diligence.
• Independent: Make sure the firm is not the same firm that prepares your financial statements.
• Cost: Expect the cost to range from $5,000 at the low end for a minimal report for a small company to more than $100,000 for a complete report for a mid-sized firm. Private equity firms like to see well-known regional firms prepare these for companies above $10 million to $25 million in revenue. Costs will vary based on:
  • Size of the business
  • How closely the financials adhere to GAAP
  • How “clean” the financial statements are
  • Complexity of the business
  • Number of entities involved
  • Industry the business operates in
  • Size of the firm you choose to hire

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

Introduction

For decades, buyers have engaged professionals to conduct a quality of earnings (QoE) analysis of companies they plan on acquiring for the extra peace of mind these give. A buyer relies on insights from the QoE report when deciding if the price they will pay for a business is fair. Recently, sellers have taken to paying for these reports before going to market. In fact, paying for a sell-side QoE report before beginning the sales process is becoming the norm for all but the smallest M&A transactions – and for good reason.

I’ve seen firsthand the difference sell-side reports make, from giving sellers a dry run of due diligence to earning the confidence of potential buyers. Other benefits are a chance to resolve issues early on, a stronger negotiating position, and a higher sales price. But not everyone understands that a QoE analysis and an audit don’t serve the same purpose – some think an audit alone will do. I’ll walk you through the differences, the benefits of each, and when it’s wise to pay for an audit vs. a QoE report.

What is a Quality of Earnings Report?

The Goal of the QoE Report

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

“Quality” of Earnings

Financial statements should be prepared consistently, accurately, and with integrity. The QoE report analyzes the financials of the target and rates its earnings as low or high quality. It aims to dismiss low-quality earnings, identify and account for accounting gimmicks, and adjust for one-time events.

• Low-Quality Earnings: Earnings “tied up” in accounts receivable have low quality, even though the earnings may have been recognized. Earnings that have been overstated due to deferred maintenance would also not be viewed as high quality.
• High-Quality Earnings: In contrast, transactions likely to continue recurring in the future are considered higher quality. Earnings are considered high quality to the extent the financial statements accurately report those earnings. To be considered high quality, earnings 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

Depending on the size of the company and the needs of both the buyer and seller, a QoE report can be long and extensive or short and focused.

Below is a list of the major components that may be included in a typical quality of earnings report:

General

Financial Statement Analysis

Every QoE report will include a detailed examination of the business’s financial statements. This includes an income statement analysis, an examination of the condition and value of the assets on the balance sheet, and an analysis of the cash flow statement if cash flow statements have been prepared by the subject business (many times they are not).

Adjustments to Financial Statements

Adjustments are commonly made to the income statements so they consistently represent the business’s operations. For example, adjustments may be made to the timing of bonuses, which may have been paid early or late for tax purposes. Adjustments may also be made based on when revenue was recognized since invoicing may have been sped up or slowed down for tax purposes. Or, there may be adjustments to bad debt, such as if a business may have written off significant bad debt when establishing a bad debt reserve would be more appropriate.

Tax Returns

The report may include an examination of tax filing positions and reportings.

Operational

Operational Risks

The QoE report presents a deeper analysis of the underlying drivers affecting business performance. Examples include trends in revenue, margins, and growth rates and their potential effects on risks associated with future earnings. The report may break down revenue by product line or customers, and it may consider customer concentration and industry trends. It can also consider product, service, and distribution channel risks, and dependencies related to key employees, intellectual property, and third parties such as suppliers. Pricing strategy, elasticity, and sustainability of gross margins may also be considered.

Related-Party Analysis

A company may have material, related-party transactions – in other words, it may transact business with entities within the same corporate family. And the buyer may want confirmation these transactions were conducted at arm’s length. Or, the buyer may want to know that a change in control of the business is unlikely to affect critical relationships, such as those with customers or suppliers.

Quality of Records

Quality of Accounting Records
The report should consider the quality and consistency of the company’s internal controls, and recent changes in the company’s accounting policies, and the impact these may have on the quality of the accounting records or stated EBITDA. The report may identify unusual trends in how the company has prepared its financial statements in the past, atypical accounting policies, and changes made to accounting procedures and practices over time – and their effect on earnings.

Proof of Revenue

Most QoE reports will include a “proof of revenue.” This includes verifying that the actual revenues reported on the income statement can be tied to the bank statements, which ensures revenues aren’t being overstated or misrepresented.

Proof of Cash

A bank reconciliation is also commonly performed, which identifies any discrepancies between financial statements and bank statements.

Income Statement

Revenue Recognition

Revenue recognition – when revenue is booked on the financial statements – may be tested to ensure reported revenue complies with the company’s accounting policies and GAAP. Variations from either may be listed in the report, and their impact on EBITDA will be identified.

Margins

The report may also inspect gross margins across the business and by product line and note recent or expected changes in gross margins and how those changes may affect future earnings.

EBITDA

The QoE analysis should walk the reader through the numbers from net income to reported EBITDA to adjusted EBITDA. The goal is to analyze and validate the pro forma EBITDA to support the purchase price or valuation of the target.

Adjustments to EBITDA

The report should also examine and verify any adjustments made to arrive at adjusted EBITDA. Source documents should be examined to verify the authenticity and reasonableness of adjustments that were made when calculating EBITDA. In some cases, additional expenses may need to be normalized, such as damage caused by a flood at a plant. Here, for example, the net income would be adjusted to account for any expenses associated with the flood that appear on the income statement, any loss of revenue, and any capital expenditures related to repairing the plant. The income statement must be normalized because the past event (the flood) will have no impact on the business’s future performance, so the adjusted EBITDA must be normalized to remove one-time events such as these. This will be one of the most important components of the QoE report.

Pro Forma EBITDA Adjustments

The report may also present adjustments to projected income statements for the purposes of calculating projected EBITDA post-closing. This is particularly helpful for strategic buyers in calculating synergies. This may include adjustments to account for recent large contracts that were awarded, potential efficiency improvements in operations, costs that may be eliminated, or potential revenue synergies that are easy to anticipate. Or, the buyer may want to adjust for other items that may change post-transaction.

Examples of these sorts of adjustments include revenue from lines of business that will cease to exist after the closing, salaries of employees who are redundant and will be laid off, facilities that will be closed, above-market compensation paid to owners, as well as loans or leases that will be paid off at closing. With a large contract win or major improvement in operational efficiency, the QoE report may analyze what the impact would have been on the historical financial statements. But these adjustments are likely to be identified in a separate pro forma adjustment section of the report.

Free Cash Flow

Many buyers use EBITDA as a convenient replacement for free cash flow. While EBITDA is quick and easy to calculate, it doesn’t always accurately represent cash available to investors unless the target doesn’t pay taxes, has no working capital needs, and doesn’t plan to invest in long-term assets. If buyers want to know the cash flow available to stakeholders, a free cash flow model may be developed that accounts for changes in working capital, capital expenditures, and taxes.

Projections

The QoE report may also include projected or pro forma income statements. This analysis is important because financial projections are often based on assumptions that can be validated by the quality of earnings report. This leads to a set of projections that can be more readily relied on because they have been developed from a sound foundation and by an independent party. The pro forma income statements may be used when calculating the future payouts of earnouts, as the basis for discounted cash flow valuation, or for numerous other purposes.

Balance Sheet

Net Working Capital (NWC) Analysis

A QoE analysis examines the amount of working capital required to operate the business without the buyer having to infuse additional capital after the closing. M&A transactions are often executed on a cash-free, debt-free basis. This means the seller keeps the cash on the balance sheet but must repay any outstanding debt at closing. The purchase price is then adjusted up or down based on the difference between the net working capital needed to operate the business (the “net working capital target”) and the actual net working capital at the closing.

Balance Sheets

The beginning and ending balance sheets may also be scrutinized to determine if revenues and expenses have been recorded in the proper periods and if liabilities and reserves have been appropriately recorded.

Debt

The report may identify any debt used in the business, to what extent the debt is normal or operational, whether it is short-term and should be assumed by the buyer, or the extent to which it’s long-term and shouldn’t be assumed by the buyer. Contingent liabilities may also be identified, 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 QoE report has many purposes and confers many advantages for both the buyer and the seller.

Here’s a summary of the main purposes and advantages of a QoE report:

For the Seller

Sell-Side Advantage #1 – Identifies Additional EBITDA Adjustments

The QoE report may uncover additional adjustments to EBITDA not previously discovered that increase profitability and, therefore, the value of the business.

Sell-Side Advantage #2 – Improves Negotiating Leverage

Performing a QoE analysis puts the seller in a strong position to negotiate a higher purchase price. The seller will know their stated EBITDA and financial information are defensible and have been independently verified. Many buyers will understand that since the seller has paid for a QoE report as part of their preparation, the buyer’s options for winnowing down the purchase price due to inaccuracies found in the financial statements during due diligence will be limited.

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

The QoE report will identify issues that can be resolved early on. Identifying these problems before going to market allows you to resolve them in a state of detached calm, as opposed to the high-pressure stakes of a multimillion-dollar transaction. If you choose not to resolve discrepancies before going to market, you will still be prepared to explain them to a buyer before they have the chance to balloon into larger issues. This allows you to retain credibility and trust with the buyer.

For sellers, the report is an opportunity to get any skeletons out of the closet and understand what’s happening under the hood of your business. This will greatly reduce risk and give you a third-party’s view of any red flags that need to be cleaned up to maximize your company’s market value. It’s always best to disclose problems early in the process, which allows you to control the narrative. This is especially true before you accept an LOI, when you may be negotiating with multiple bidders. If you disclose issues in advance, the bidders will take your disclosure into account when making their final bids and may be in a position to accept the issue if they’re bidding against other buyers.

If the issue is discovered after you accept the LOI, there will be one buyer remaining, and you will have lost your negotiating advantage. That buyer will be in a strong position to propose a purchase price reduction or even walk away from the deal. If the buyer discovers something material you failed to disclose, they’ll wonder what other issues you may have failed to disclose. Their antennae will be raised, they’ll perform more stringent due diligence as a result, and they’ll propose strict provisions in the transaction structure and purchase agreement to further protect themselves from undisclosed problems. Other bidders may not have been as concerned had this been disclosed before the LOI and may not have made an issue out of it.

Sell-Side Advantage #4 – Improves Positioning

If your deal comes with third-party validation, potential buyers are more likely to believe your story and pursue your business. A QoE report packages your company nicely and reflects how this will be a wise investment for the buyer.

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

The sell-side QoE report could be described as a practice run for what you and your management team will experience during the buyer’s due diligence process. Since many sellers have not been through due diligence before, preparation is critical. Once a buyer is interested, you can provide access to the existing data room, which will accelerate the process faster than if all materials need to be assembled from scratch at that time. Time kills deals. The longer the buyer’s due diligence process lasts, the more opportunity there is for the deal to fall apart as future events deter the buyer’s interest. The reality is no deal is finished until the purchase agreement is signed, and every day in between is a chance for the deal to fall through.

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

Sell-Side Advantage #6 – Prepares You for Due Diligence

As a result of the sell-side QoE process, you will have assembled many of the documents and data the buyer’s diligence team will request. Doing a sell-side QoE analysis ensures all the information is collected before the buy-side does its QoE analysis, and the process can move along much faster as a result.

Sell-Side Advantage #7 – Supports a Higher Purchase Price

A sell-side QoE report often results in a higher sales price. Because M&A transactions are valued as a multiple of earnings, the higher the earnings, the higher the value. If issues can be identified and remedied before going to market, this will lead to higher-quality earnings, and the business will receive a higher valuation as a result.

Sell-Side Advantage #8 – Provides You an Advocate During Buyer Diligence

The sell-side QoE team often conducts financial due diligence for buyers in other transactions. The team has the technical knowledge to respond to key accounting questions that may arise during the buyer’s due diligence. The sell-side team commonly schedules a call with the buyer’s due diligence team to answer questions they may have after reading the report. Often, points of dissension can be swiftly handled in these calls, which could be more difficult to handle without an experienced M&A expert on your side. While the report is meant to be an objective assessment of a company’s earnings, it can also be nefariously used as a weapon by potential buyers to challenge or reduce the purchase price.

A potential buyer may use their QoE report as leverage to reduce the dollar amount of EBITDA or decrease the number of add-backs to knock down the purchase price and avoid paying what the business is really worth. It’s vital to have an experienced M&A advisor in place to help rebut buyer objections and navigate other problems to safeguard against reductions in the sale price. If you don’t have a sell-side QoE report, the buy-side QoE firm will have greater scope to be aggressive in identifying accounting issues. If, instead, you retain a reputable firm to perform a sell-side QoE analysis, there would be less scope for these adjustments. Even if the buy-side QoE firm does raise issues, you’ll have an advocate who speaks the same accounting language to negotiate a reasonable resolution.

Sell-Side Advantage #9 – Establishes an Advantageous Net Working Capital Target

A sell-side QoE report also helps establish the seller’s position in the negotiation regarding what an appropriate net working capital target amount should be. It’s generally in your interest for the net working capital target to be as low as possible. A low net working capital target reduces the possibility of a purchase price decrease related to the difference between the net working capital actually delivered and the net working capital target amount. It can identify any accounts that may need to be removed from the net working capital calculation for various reasons. While the definition of net working capital as current assets minus current liabilities is objective, in reality, a particular net working capital target for a specific situation is a matter of negotiation. Having an advocate on your side who specializes in setting net working capital targets is crucial.

Sell-Side Advantage #10 – Explains Problems

M&A advisors, who have experience seeing deals through to close, can be helpful in explaining information in ways that will minimize the potential impact on a deal’s chance of success. You increase your leverage in negotiating the deal because you now know more about the strengths and weaknesses of your business, as seen through a potential buyer’s eyes.

Sell-Side Advantage #11 – Helps Organize Documents in Advance

Many of the documents needed for due diligence are also needed for the QoE report. A sell-side QoE report will give you a leg up on getting all these documents accumulated into a virtual data room in advance. This will speed up the process and minimize the likelihood of issues killing the deal before the closing.

Sell-Side Advantage #12 – Demonstrates Commitment to Buyers

Spending the time and effort to prepare a QoE report before you go to market tells investors you’re serious about selling your company. Prospective buyers don’t want to put in a ton of effort to have you decide at the end that you don’t want to sell.

For the Buyer

Buy-Side Advantage #1 – Provides a Post-Closing Roadmap

The buyer will have a roadmap of any accounting policies and procedures that need to be resolved post-close and what needs to be improved operationally to increase the business’s profitability. This provides a clear integration roadmap for the buyer, which can speed up the process and minimize problems during the transition.

Buy-Side Advantage #2 – Helps Estimate Bank Financing

Banks examine various ratios when determining whether to finance a deal and for what amount. It’s important for them to understand how much debt the target can service, which is aided by the normalized EBITDA and net working capital reports within the QoE report. The fact the report is prepared by an independent party gives the bank additional confidence.

Buy-Side Advantage #3 – Ensures Proper Diligence

The report allows the potential buyer to kick the financial and operational tires to ensure there aren’t inflated earnings or wonky accounting policies lurking around the corner. It helps the buyer understand what’s happening with the business before committing to the purchase.

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 – Facilitates a Greater Understanding of the Business

While evaluating the numbers is important, the commentary and explanation behind the numbers that enable the parties to understand the business are some of the most valuable information in the report. For sellers, the report provides a sound footing to understand what the business is worth. It strengthens your negotiating position. For both buyer and seller, the report may help give a greater understanding of the company’s management team, the strength of internal controls, key performance indicators, and unusual factors that affect the business, such as one-time events or those that aren’t sustainable over time.

The buyer will have more certainty regarding their understanding of the business and the reliability of the financial statements. More certainty equals less risk, which can often work out to a higher purchase price. With a stronger understanding of risk, business performance can be projected with greater certainty, lending more credibility to projections that have been prepared.

Advantages for Both Parties #2 – Increases Buyer Confidence and Interest

As in any negotiation, buyers have a range of prices they may be willing to pay. If they perceive a business to have unreliable accounting records and obstacles to overcome, they’ll bid on the low end. If they read the sell-side QoE report, develop confidence in the accounting records, and feel the business is free from obvious obstacles, they’ll likely be comfortable bidding at the upper end. A buyer may be willing to pay a higher multiple on the same earnings if the deal seems clean and easy to transact. The difference between an extra one or two times earnings in transaction valuation could amount to millions of dollars in favor of the seller.

Buyers bid high when they perceive a business is clean. In addition, the multiple dictated by the market is influenced by how many interested buyers exist. If the seller can distribute a QoE report that reinforces the attractiveness of a deal, there will be a greater number of interested buyers. In contrast, without a sell-side QoE report, there may still be market interest, but the total demand could be weaker. This would exert downward pressure on the valuation.

Advantages for Both Parties #3 – Increases the Likelihood of Closing

QoE firms present financial statements the way buyers think about them. This helps eliminate misunderstandings or miscommunications related to accounting interpretations. Everyone will be on the same page regarding accounting policies, such as accrual vs. cash, revenue recognition policies, and so on. Most private equity buyers use debt to fund transactions which drives purchase price. Lenders won’t usually issue final term sheets without the sellers conducting QoE studies. Therefore, having a QoE analysis done early helps ensure valuations presented in LOIs are more precise and accurate. This increases the likelihood of closing.

Advantages for Both Parties #4 – Verifies EBITDA

The QoE report helps the parties understand the true earnings potential of the business and what the historical run rate, or financial performance, has been. Since a multiple of EBITDA is the most widely used valuation methodology, having the stated EBITDA verified by an outside expert can help legitimize the valuation and price paid.

Advantages for Both Parties #5 – Serves as a Reliable Basis for Forecasts

Ultimately, bidders value a business based on its expected future performance and, therefore, projections, which are sensitive to underlying assumptions. Because the QoE report will validate the core assumptions, it will strengthen confidence in the forecasts. Since most forecasts rely on the most recent years’ data, providing reliable EBITDA and cash flow numbers will improve forecast accuracy, which offers further confidence in the projections.

Advantages for Both Parties #6 – Offers an Objective Perspective

An outside firm brings objectivity to the transaction and can identify common issues that might concern buyers. This can catch issues management might not be aware of. The QoE report gives both parties a third party’s view of potential red flags or areas of concern.

Advantages for Both Parties #7 – Minimizes the Risk of Post-Closing Working Capital Disputes

One area for disagreement and even litigation after a transaction closes is a dispute over net working capital. The sell-side QoE team can work with the parties’ attorneys to review the purchase agreement and make sure it addresses any eventualities that could arise related to net working capital calculations. M&A accounting and legal experts are more likely to craft a document that minimizes litigation risk.

Advantages for Both Parties #8 – Shortens the Deal Timeline

Many buyers won’t engage their legal counsel to draft closing documents until the QoE report is complete because of the risk of uncovering something important that may jeopardize the deal. If a sell-side QoE analysis is performed in advance, this may instill confidence in the buyer, and they may speed up their transaction timeline as a result.

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 advantage of the QoE report is it enables the seller to identify and resolve problems before going to market. Failure to address red flags can affect the company’s valuation and future performance.

Here’s a summary of some of the most common problems discovered in a QoE analysis:

• Aggressive Accounting Practices: Some owners take an aggressive accounting position to either artificially inflate earnings to improve the valuation or artificially deflate earnings to minimize taxes. A QoE report will identify if either has occurred and, if so, suggest how to resolve the problem.
• Data That Can’t be Reconciled: Another problem is when financial statements can’t be reconciled with bank statements or tax returns. If they can’t, it’s important to find out why. A QoE report will identify discrepancies between the two, which can be used to resolve the differences.
• Improper Revenue Recognition: Revenue is commonly recognized in the wrong period, resulting from unclear accounting policies or processes, or failure to capture revenue, rebates, discounts, or returns in the correct period.
  Improper Capitalization of Expenses: Only long-term expenses should be capitalized. The report will identify items that should have been expensed or any expenses that should have been capitalized.
• Non-GAAP Accounting: Adherence to generally accepted accounting principles (GAAP) ensures consistency and helps avoid accidentally or deliberately misstating the company’s financial status. The QoE firm will identify variances from GAAP and may advise if restating the financial statements is recommended.
• Improper Inventory Tracking: Inaccurate inventory controls affect the cost of goods sold, gross margins, and, therefore, EBITDA. If ending inventory balances are not recorded properly, this can result in understated or overstated EBITDA. This inaccuracy can reflect loose management or accounting practices or potentially indicate a failure to record the full cost of purchased inventory.
• Related-Party Transactions: Many companies do business with other entities within their corporate family. In many cases, these transactions aren’t conducted at arm’s length, and the resulting revenue or expenses may not align with what it would have been if the transaction were conducted with a third party. These transactions can make it easy to inflate income fraudulently. For example, the company could “sell” a product to its related entity. The company could then cancel the transaction, transact with related entities at artificially inflated rates to pump up revenue or buy products or services from related parties at discounted rates to artificially reduce expenses.
• Unreported or Contingent Liabilities: Bad debts, damaged goods accounted for as inventory, or a pending lawsuit are examples of unreported or contingent liabilities. These may represent future obligations for the company, which are often not recorded on the company’s balance sheet.
• Customer Concentration Issues: Another problem is a significant percentage of revenue being generated from one customer. Losing a major source of revenue will have a negative effect on the company’s valuation. It may indicate a deeper problem related to product quality or customer service, and this could spell even bigger trouble for the company.
• Disengaged Management Teams: If the management team doesn’t regularly review the financial statements, it’s easier for someone on the inside to manipulate revenue or expenses. It can signal to the buyer that ownership is not on top of the business and can result in a loss of trust in the owner or the management team.
• Unethical Behavior: A final but less common problem is unethical behavior – enticing someone to hire you by paying them cash or selling something off the books. These issues raise suspicion among buyers and may cause them to wonder how many other skeletons are in the closet. In some cases, it will kill a deal. Warren Buffett is famously quoted as saying, “You can’t make a good deal with a bad person.” Most sophisticated buyers agree and terminate the transaction without further comment upon discovery of unethical behavior. Even if they do proceed, in most cases, the owner will be required to stay for either a transition period or longer, and it’s unlikely a buyer will want a less-than-trustworthy party involved in the operations of the business post-closing.

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

The quality of earnings report is called a “sell-side QoE” if it’s requested by the seller or a “buy-side QoE” if requested by the buyer. The contents are generally the same, regardless of who requests it.

Who pays for the report?

Sell Side

If it is a sell-side QoE report, the seller pays, and since it almost always results in a higher valuation and a smoother transaction, the investment pays for itself.

Buy Side

If the buyer asks for it, the buyer typically pays. Some buyers may ask the seller to pay half the fee if the business is large enough that the financial statements should have been consistently audited over the years, but the seller has avoided paying auditing fees. I would argue a firm would have a conflict of interest if it were to represent both the buyer and the seller.

The Buy-Side QoE Report

The Buyer’s Objectives

For a buyer, the objective of a QoE report is to give them greater confidence their investment will work out the way they expect it to and to validate the earnings their offer is based on. It helps the buyer understand account balances, cash flows, and general operations of the business in better detail.

Additional Insights

The report will offer the buyer a rich picture of how strong the business really is and whether its performance is likely to continue. It can help the buyer obtain financing or approval from their board or investment committees. While a QoE report doesn’t replace the buyers’ financial due diligence, it’s an important, independent tool for understanding the business.

Who Pays

Buyers sometimes push back on paying for a quality of earnings report because of the cost. But if the insights gained result in a lower sale price or yield useful information regarding how to cut costs once the business is acquired, the investment can be justified.

The Sell-Side QoE Report

The Seller’s Objectives

For the seller, performing a QoE analysis will help spot and resolve problems before going to market. All sellers want a deal to go through as quickly as possible and without surprises. The analysis will examine the business through the eyes of potential buyers. This process dramatically improves the likelihood of a successful close, maximizes value, and can accelerate the timeline by allowing you to fix issues early on.

Why a Third-Party Perspective Is Important

As an entrepreneur, you understand your business inside and out and have accepted the risks of your business and industry. But, entrepreneurs can get blinded by familiarity. Buyers may come from a different segment of the industry or organize their businesses differently from the company they plan to acquire. Investors, such as private equity firms, may not be familiar with the industry. A QoE report can give owners a new perspective of their business they otherwise wouldn’t receive.

Why Sell-Side QoE Reports Are Now the Norm

In recent years, sellers have become more proactive and have paid for QoE reports on themselves before going to market. This is similar to performing a home inspection before selling your house. Obtaining a sell-side QoE report gives buyers confidence, uncovers issues before they become a problem, speeds up the transaction process, and is a strong signal that the seller is serious. Sell-side QoE reports are becoming standard, so not having one puts you at a disadvantage.

The Importance of Preparation

If the report uncovers something negative, you can fix it before going to market, or at least disclose it and avoid surprises that can affect the purchase price. Sellers who plan to sell in the near future can obtain a QoE report now and have plenty of time to correct any issues before going to market. A refresh of the report can be done when you are ready to go to market, and should be less expensive than the original report.

Reducing Risk

A QoE report allows a seller to get an honest look at their businesses before entering the market. It identifies inconsistencies in financials and areas of concern to address before selling. It will tell management exactly what to fix to maximize the price of the business. It will help you eliminate nasty surprises that could reduce the purchase price or kill the transaction entirely.

Impact on the Transaction

A credible sell-side QoE report can help support a higher price. You can use it to negotiate better terms, such as more cash at closing, and fewer contingent payments, such as earnouts. It can help smooth the due diligence process, and it can lead to less stringent reps and warranties terms or lower reps and warranties insurance premiums.

Identifying Additional Adjustments

While both the seller’s and the buyer’s QoE teams will identify adjustments that can affect adjusted EBITDA, the buyer’s diligence team has no incentive to identify add-backs that increase EBITDA and may therefore cause their client to pay more for the business. If the seller retains a QoE provider on their own, the sell-side analyst is much more likely to uncover additional adjustments that will have a positive impact on the valuation that a buy-side QoE report is less likely to uncover.

Timing

If the buyer requests the QoE report, it’s almost always done so after a letter of intent (LOI) is signed and the parties have entered into an exclusivity period and are performing due diligence. Few buyers will be willing to commit to the time and expense of a QoE report without an exclusive commitment from the seller.

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

One of the most common misconceptions I encounter is that a QoE report and audited financial statements are the same. Some people may understand these differ yet believe they serve the same function.

Are an audit and QoE report the same? If not, what’s the difference?

An Audit

Audits are backward-looking – they’re typically balance sheet focused and confirm whether financial statements conform to generally accepted accounting principles (GAAP). Also of note, an audit is an attest service: an independent review of a company’s financial statements by a CPA. It follows specific guidelines and processes. In contrast, a QoE report is a consulting engagement. Another difference is an audit must be performed by a CPA and doesn’t typically cover the two most recent interim periods.

A QoE Report

A QoE report is mainly forward-looking – it focuses on what the name implies: the quality of the earnings. It examines the income statement, or earnings, and is less concerned that the financial statements comply with GAAP. A QoE report involves many analytical procedures designed to gain a deeper understanding of the risks of a company in a potential acquisition. It considers the risk of receiving those earnings moving forward. A quality of earnings report does not need to be performed by a CPA, and it usually covers the three to five most recent fiscal years, and the interim period.

QoE reports differ from audits for other reasons because they:

• Take into account add-backs and adjustments to the financial statements, which are a departure from GAAP.
• Give the reader a better understanding of normal operating conditions and financial performance.
• Analyze the potential impact of subjective factors, such as concentrations of risk, industry factors, economic factors, and factors that can affect the financial performance of the business.
• Are both backward and forward-looking.
• Provide insight into a company’s current and future earning potential.
• Analyze the operations to identify how the business might perform in the future.
• Are a consulting engagement, not an attest service, providing flexibility in the approach and scope.
• Do not have a defined form or level of materiality.
• Are offered in a variety of formats – there’s no universally accepted format for a QoE report.
• Provide insights and perspectives audited financial statements typically lack.

Do I need both an audit and a QoE report?
Clients often ask if there’s a need for a QoE report if their financials have been audited. The simple answer is yes – because an audit and QoE report aren’t the same.

The main purpose of a QoE report is to facilitate an M&A transaction, whereas the primary purpose of an audit is to confirm whether the financial statements comply with GAAP and accurately reflect the financial position of a company.

A QoE report will provide more value than an audit if you’re considering selling your company, and it will put you in a much better position to sell your company for top dollar. CPAs who regularly perform QoE analyses know exactly what buyers look for in M&A transactions. So, they’re in an ideal position to identify issues related to your financial statements that must be resolved before going to market.

Most buyers will retain a firm to perform a buy-side QoE analysis even if the seller has had one. But it’s prudent for the seller to perform a QoE analysis even if the buyer will have one prepared. This bears repeating: It’s best practice for sellers to perform their own QoE analysis even though the buyer will conduct financial due diligence and hire their own firm to prepare a QoE.

The Quality of Earnings Analysis Process

Scope

The scope of each QoE report, and therefore the process of preparing the report, will vary based on the company’s size, the transaction, and the buyer’s comfort level during due diligence. Here’s a general description of the process.

Gather Information

The first step in performing any QoE report is to collect and organize the information needed for the analysis.

The main sources of information include:

• Historical financial statements (income statements, balance sheets, cash flow statements) for the last three to five years, including the monthly trial balances
• Current (interim) financial statements
• Forecast financial information, if available
• Copies of any loan or debt agreements
• Federal, state, and local tax returns for the last three to five years
• Bank statements
• Federal income tax returns
• Management interviews

Depending on the size of the business, the CFO, controller, and owner are often the ones providing the accounting and finance information to the firm preparing the report. This may include background on the company, insights on trends in the financials, or answers to any other questions the analyst may have.

Preliminary Analysis and Discussion

Preliminary Analysis

Once the information is gathered and organized, the analyst may perform a preliminary analysis. Sometimes, older companies don’t have upgraded systems, and information must be obtained using creative methods. Other times, system limitations may prevent the owner from accessing or supplying the needed data. For example, the analyst may want to analyze gross margin trends by product line, but the company may not track margins by product. Another common issue is when costs aren’t properly attributed. Doing a preliminary analysis gives you a start for the QoE report.

Discussion

If the data doesn’t match or add up to the reported numbers, those issues must be discussed with the seller’s management team. When analyzing the information, it’s important for the analyst to put themselves in the buyer’s shoes to try to understand their objectives. In many cases, the analyst may have to ask the owner or management team the same question two or three times to peel back the layers of the onion, or probe deeper to truly understand the issue.

Conflicting Information

The analyst may hear conflicting information from the in-house bookkeeper or accountant, owner, and management team and may receive different answers to the same questions worded differently. In many cases, the parties may give the analyst the answer they think they want to hear. Only after multiple probing questions may the analyst truly understand the issue enough to address it in the report.

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

Adjustments to the Financial Statements

The next step is to remove all non-recurring revenue and expenses so the financial statements reflect only the core business activities.

Examples of non-recurring income include:

• Gains on the sale of assets
• Insurance claim awards, litigation rewards, or workers’ compensation refunds
• Unusual 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:

• Family members on the payroll who aren’t involved in the business
• Owners’ personal expenses or perks that are run through the business
• Expenses associated with non-recurring revenue
• Litigation fees and/or losses
• Losses on sale of assets
• Losses on discontinued operations
• Losses due to a natural disaster

One of the primary objectives of a QoE report is to understand how the core business is performing. Removing non-recurring income and expenses is a critical step in the process that allows the readers of the report to analyze the core business operations.

Detailed Analysis

Once the financial information has been gathered and analyzed and the financial statements have been adjusted, it is time for a deep dive into the operations of the business. The true strengths and weaknesses of the business will be examined in depth to help the buyer make the most informed decision possible about the business.

The detailed analysis may include an examination of the following:

• Age of equipment
• Age of the workforce
• Customer concentration
• Employee compensation
• Employee turnover
• Inventory turnover
• Key employee issues or risks
• Monthly and yearly trend analysis
• Potential capital expenditure (CapEx) needs
• Profit margin by customer, product, or service
• Vendor concentration

This type of analysis can uncover critical issues that a preliminary review of the financial statements would not discover. A well-prepared QoE report will include observations on each area examined in the analysis, while a less detailed report will include a quantitative analysis with no commentary or opinion. It’s this deeper level of analysis and commentary that sets apart a well-prepared QoE report from a poorly prepared one.

Finished Product

QoE Report vs. Financial Due Diligence

A QoE report is part of a more comprehensive financial due diligence analysis or process. The report is sometimes the primary component of a larger financial due diligence analysis, providing a clearer view of a company’s ability to generate future cash flows based on past results.

The Format

While there’s no standard format and set of content for a QoE report (in contrast to an audit), the finished product is usually a PDF file or spreadsheet. If it’s a spreadsheet, it will contain dozens of tabs, walking the reader from the original financial statements to adjusted EBITDA.

Additional Information

The QoE report will include information regarding proof of revenue and cash, reconciliation from the financial statements to the bank statements, projections, and so on. Each area will usually include a deep dive into the numbers behind the analysis for the particular area with an explanation and implications of the findings.

Stakeholders

Since other stakeholders also need assurance the investment is wise, and that the financials of the target company can be relied on, the QoE and financial due diligence reports are critical. The QoE report may be shared with other stakeholders, such as lenders, private equity investment committees, insurance companies, and key related parties. Private equity investors typically insist on these reports, not only for their own independent analysis but also to provide another perspective on the transaction that they may have missed. The reports are commonly requested by boards of directors of strategic buyers or public firms, or the investment committees of private equity firms.

Timing

QoE studies typically take around 30 to 45 days, although the timing depends on how quickly the owner or management team can supply the information to the analyst and respond to questions. Completing the QoE report concurrently with the investment banker’s process may eliminate any post-LOI delays.

Hiring a QoE Provider

The Importance of Experience

• QoE Experience: My number one piece of advice I have when hiring a firm to conduct a QoE analysis is to pick a firm that has a dedicated person or department focused exclusively on providing QoE services.
• Types of Firms: QoE studies are usually conducted by CPA firms and specialized financial due diligence firms.
• Reputation: Hire a firm with a reputation for quality and the ability to withstand the rigors of private equity or strategic buyer financial due diligence.
• M&A Experience: The team you hire should have an extensive background in conducting financial due diligence processes in M&A transactions and, ideally, in your industry.
• Independent: Additionally, the firm that prepares your QoE report should not be the same firm that prepares your financial statements.

How Much Does a QoE Report Cost?

Price Range

QoE studies can range dramatically in price from $5,000 at the low end for a minimal report for a small company to more than $100,000 for a complete report for a mid-sized firm.

• Small Companies: If you own a company with less than $10 million in revenue and relatively simple operations, you can probably spend as little as $10,000 to $20,000 for a local firm to produce the report.
• Mid-Sized Companies: If your business generates over $10 million in revenue, I suggest stepping up to a regional firm to give the report added credibility.

The Right Firm
If you go with a small to mid-sized firm, their fee structure will be optimized for the middle market and will be favorable relative to larger accounting firms for the same scope of work. Private equity firms typically like to see well-known regional firms prepare QoE reports for firms above $10 million to $25 million in revenue.

Cost and timing will vary based on several variables:

• The size of the business
• How closely the financials adhere to GAAP
• How “clean” the financial statements are
• The complexity of the business, such as whether the business carries inventory
• The number of entities involved
• The industry the business operates in
• The size of the firm you choose to hire

Learn More about the QoE

If you’d like to learn more about how a quality of earnings report can impact the sale of your business, check out these podcasts where I have discussed real-life applications of a QoE analysis with experts in the industry. You can find these podcasts on the Morgan & Westfield website.

Podcasts

• Cooking the Books
• Top Seven Issues Today Critical to Understanding Quality of Earnings
• Financial Due Diligence

Conclusion

Many investment bankers advise sellers to hire a QoE specialist to conduct a QoE analysis and prepare a report. In fact, this is becoming standard, and for good reason. These reports are usually prepared by CPAs and specialist financial due diligence firms. They have an insider’s view of what buyers look for, so they can pick up on issues that must be resolved. The problems that arise range from innocent accounting oversights, such as simple errors, to unconventional accounting practices or gimmicks.

The QoE report paints a clear picture of the company’s financial statements and internal controls, and it uncovers what’s really happening in the business. There are countless upsides. As a seller, it gives you third-party validation of your numbers, which makes potential buyers more likely to believe their accuracy and keen to pursue your business. It helps strengthen your position in negotiations. And it often leads to a higher sales price, not to mention it can speed up the sale process, cut the risk of litigation after the closing, and more.