Quality of Earnings Reports as Part of a Sale Transaction: The Who, The What and The Why

As part of the preparation for a potential sale of your business, it is important to be aware of all the steps that may occur during the due diligence phase prior to closing a deal. The due diligence process covers a wide range of areas including operations, legal and financial matters. During a sale, it is likely that the services of an independent third party will be retained by the potential investor or buyer to compile a Quality of Earnings (QoE) report. QoE reports are used regularly by middle market private equity firms and strategic buyers in order to evaluate your company’s financial statements to make sure the numbers used in valuing the business are verified by a third party

When anticipating a QoE report request for your business sale transaction, you should consider the following factors:

Purpose

Think of the QoE Report like the buyer’s process of purchasing real estate. Would you trust in buying new property “as-is” without getting it inspected first by an expert to make sure everything is in order?

QoE reports are typically used by potential investors or buyers as part of the due diligence phase of the sales process for two purposes:

• Confirm that the EBITDA and add-back amounts put forth are accurate and traceable to source financial information
• Confirm that the reported earnings are representative of your company’s real income. Net income is not a 100% precise indicator of how your company could be performing

The QoE report should be thought of as a tool utilized by the potential investor or buyer to validate key pieces of financial information and identify items of interest or financial situations that require further due diligence.

Scope

A QoE report is different from a complete financial audit, as it will be more limited in scope and the work usually sourced out to an independent third party (i.e. external due diligence experts or a qualified CPA firm) during the due diligence process. The scope of each QoE report will be unique depending upon the nature of the transaction and the size of the company or business operations being acquired, as well as the desired level of comfort during the due diligence process.

In general, a financial due diligence process would typically involve a review of the following areas: historical financial results; current financial position; forecasted financial results; working capital requirements; employee entitlements provisions; valuation implications; risks and opportunities; EBITDA add-backs; and taxation implications.

As a business owner, you can expect the QoE Report to focus more on financial-related due diligence procedures such as the earnings capability of the company, key business drivers, trends in profitability, and any identified areas of significant risk.

Preparation

The information required to complete a QoE Report is dictated by the agreed-upon scope as well as the reporting capabilities of the target company. The main sources of information for a QoE report include:

• Historical financial data for the last three-five years, (preferably audited or reviewed), including the monthly and trial balance detail
• Current financial data such as year-to-date management accounts
• Forecast financial information (next 12-18 months)
• Copies of any loan or debt agreements
• Federal, state, and local tax returns for the last three-five years
• Management interviews

How Can a QoE Report Affect the Sale Process?

The QoE report is one of the most crucial pieces of the post-LOI due diligence process. Since the aim of the QoE report is to support or challenge the company’s performance on which an offer was based, a QoE report can have a considerable impact on the transaction.

While the report is meant to be an objective assessment of a company’s earnings, it can be used as a tool by potential buyers to challenge or reduce the purchase price. Commonly, a potential buyer will use the QoE report as leverage to reduce the dollar amount of EBITDA or number of add-backs to “knock down” the price and avoid paying more. It is important to have an experienced M&A advisor in place to help rebut any buyer objections and navigate other problems that may arise during the process to safeguard against reductions in the sale price.

How Can a Seller Prepare for this Phase of Diligence and Minimize Risk?

Having professionally audited, or at least reviewed financial statements can help to increase the accuracy of reporting for historical periods. Implementing more robust reporting/data capabilities prior to the sales process can help to ensure that correct information is able to be collected when needed in a quick and efficient manner.

In cases of concern, (i.e. complex financials, potential inaccuracies, etc.), a seller can prepare a pre-sale, sell-side QoE report to get ahead of potential issues. In all cases, having a professional transaction advisor on your side allows a seller to adequately prepare for a QoE report, as well as address potential issues that will arise from a QoE report in real time.

The Way Forward

The QoE Report phase is not simply a standard checklist of procedures to provide a ‘tick’ for the financial piece of the due diligence process. When done properly, the QoE Report provides valuable information to the buyer to support/oppose the proposed valuation by the seller and identify any other issues that may need to be addressed.

If you own a small business and you are anticipating a sale It is important to retain the services of an experienced M&A advisor to help guide you through the QoE process. A business owner may not have the relevant knowledge or skill necessary to make sure items that will detract from the overall value or “deal-breakers” are solved prior to the potential QoE and due diligence process. Having the right team in place preceding the sale of a business can be vital to ensuring all the appropriate steps are taken to facilitate a successful sale.