Quality of Earnings

Quality of Earnings

During the final stage of your search, while under LOI, you will need to verify what the seller has provided as to their financial health. This level of accounting diligence is best done by an outsider who has the skills and competence to assess the company you want to purchase and their financial reporting systems upon which the projections you developed to price the offer were based.

This may be the first time that you are putting significant cash at risk, since the chances that the Letter of Intent moves to an actual closing is only 33% (See Blog Post – Getting to Closing) and you will have to pay for this outside service whether you close or not. It is therefore very important to understand the value of a Quality of Earnings (QoE) report, its cost, who to hire to complete it, and most importantly the appropriate time to initiate it. As one searcher points out, “It’s one of the only really concrete things that you can know in the diligence process, almost everything else is analytical judgment.”

You get what you pay for

The QoE report can be 70+ pages in length or as short as three. A more complete report would include a 3-4 year historical review of earnings and an objective assessment of the EBITDA calculation as presented by the intermediary or the seller. A verification of receivables and payables balances, along with their aging, will be provided. If inventory exists, an evaluation of its cost basis will be made.

In some instances, it may be necessary to convert a “cash reporting” system to the more common “GAAP accrual system” that will be required after closing. There will be a recommendation about how to handle the closing balance sheet and how to account for closing expenses, good-will and Section 336(e) treatment in the case of a stock purchase.

You can expect that they may also perform a historical bridge analysis that explains changes from year-to-year in revenue and income. There may be review of customer concentration, overhead expenses, bad debts, transactions with related parties, reserves and outstanding legal issues. You will see an opinion about the financial controls and systems that are in place as the result of interviews with the employees who process payments received from customers, issue payments to vendors, and process payroll.

Generally, there is not an independent “valuation” included in the QoE, which may be a requirement of your debt lender and would be commissioned separately by them to insure objectivity. For $3-10K, most CPA firms will add the valuation to their report.

You will always want a verification of working capital and an understanding of each balance sheet line item from which it is derived. This will become very important during detailed discussions with sellers on how to handle increases/decreases in working capital by the time the closing date comes around. This is the time that the current assets and liabilities from the balance sheet should be confirmed against the LOI details about the Working Capital “peg”. Do not underestimate this – many a relationship between buyer and seller have been soured by a misunderstanding around working capital.

With some preliminary work during due diligence, depending on your own skills and comfort with accounting methods, you may be able to streamline their activities and avoid duplicate efforts by the owner. Tim Meng, at Thorn Hill Bay, found that he “did a lot of the preliminary heavy lifting, the accountant had most of what they needed on day one of their visit”. Adam Barker at New Forest learned the hard way when his accountant showed up on-site, and within an hour discovered issues that could have been identified in a “bench” review before leaving their office from the data provided by the client.”

Retaining a firm to perform the audit

It will be critical to understand and define what activities will be completed by the accountant you select. Requesting a “scope of work” along with their bid to provide the services will help you understand what “levels” of output you can expect at a given cost level. They will be able to examine what you have received during your due diligence to-date and let you know what additional inputs they will need to speed up the process.

One searcher used a rigorous process with three potential providers, “I made a determination based on a combination of (i) price, (ii) perception of their ability to provide value-add observations and financial guidance, (iii) perceptions around their ability to run projects/manage projects and (iv) how well they understood the seller’s business/accounting issues prior to engaging in the process.”

Most large accounting firms offer a QoE service, seeing it as a way to retain new customers once the acquisition is completed. There are others who specialize in QoE’s specifically. Within the search community, there are a number of commonly used firms, which gave comfort to Tyler Hogan at East Range Partners, “The firm we picked had worked with other searchers giving us more confidence that we weren’t messing anything up or missing anything.” Blum Shapiro, Hood & Strong, Plante Moran, the Boulay Group and Mazars Group (Europe) were being utilized in a survey of a dozen searchers/CEO’s. They also reported an average time of 5 weeks to complete a report, with a range from 3 weeks to 8 weeks.

Costs for these services run as low as $7K for a very simple summary report to a high of $80K and an average of $30K. Payments can generally be deferred to the closing date. A few searchers have reported being able to have these costs rollover into the next deal at a 50% discount. As one searcher reports, “We would receive a discount if the deal blew up, but we were still on the hook.” Self-funded searchers are particularly concerned about these costs in the event that they “fail to find”, and for any searcher this is a great opportunity to practice negotiation skills!

When is the right time to start the process?

As one of the first and “permanent” cash outlays, the QoE is often delayed during due diligence until most of the significant details have been hammered out with the seller around the “soft issues” like seller engagement after closing and preparation of all the financial data needed for the QofE vendor. As one searcher pointed out, “it was one of the more agonizing decisions of when to release the CPA’s on a deal, and we always released them too late due to fear of broken deal costs.”

While PE firms may often start this process immediately upon LOI signature, you will want wait until you are into the debt financing process with banks and lenders. The lenders will be specific about what level of detail they expect from your QofE. At least one round of discussions with your investors should be completed before you make the commitment. Generally, legal documents are not started until after at least the preliminary results of the the QofE are in hand. A searcher said, “we always found ourselves doing a lot of the financial diligence ourselves in the first month post LOI to make sure that it was still an actionable deal and then hiring on the CPAs to do the work afterwards.”

In more than half the cases, the QoE report surfaces enough issues that lead to additional negotiations with the seller. It may also yield information that will cause the deal to die. In one case the auditors discovered some significant tax filing errors that came as a surprise to the seller. In another deal, Marc Cussenot, a self-funded searcher/CEO of Precision Concrete Cutting, observed: “substantial discrepancies were discovered while converting financials from cash-basis to accrual-basis that I would not have seen otherwise. That was the main reason why I passed on the deal.”

In many situations, the seller’s EBITDA “add-backs” just don’t stand up under scrutiny nor historical precedent and undermine the overall valuation. In any of these situations, you will at least now have factual data to underpin your re-negotiations. In any case, you want to be transparent with the business owner about this phase of the process and what some expected outcomes may be. These discoveries are the primary reason that closings get extended to the average of 5.1 months when initial language in an LOI may be 60 or 90 days.

Where is the value?

In most instances where there is a lender involved, they will require a QoE by the time of closing. One searcher reported that “After receiving 60 “no”s from banks without a QoE, I resent it to them with the report. It turned two lenders’ “no”s into “yes”s.” The QoE can also be used to just understand the business better, “It helped me out a lot to get a more detailed understanding of the cash flow in the company and cash-in/cash-out is very difficult to fake or fudge,” observed one searcher/CEO.

Investors will have similar expectations about confirming the financials in the business. Tim Meng found, “I did extensive financial analysis on my own supported by my team of interns. I only used QoE to confirm my own findings and build confidence with investors and bankers.” While investors may not be as impatient to require it up front, they will want the comfort of having it before closing. Mark Anderegg of Madison Equity Associates reports, “There is value to getting all financing sources comfortable with the cash flow being acquired.”

Several searchers reported that the “full report” was not of as much value as they thought it would be, and one even observed that it was a waste of money. In particular, the “valuation” reports did not hold up under scrutiny by many searchers, yet were accepted by the lenders despite questionable “comparables” and poorly-conceived discounted cash flow assumptions.

In the end, most felt that the QoE added credibility to the searcher’s efforts in all of their discussions during due diligence with bankers, mezzanine lenders, legal advisors, insurance and benefits providers and, of course, the seller and their intermediaries. Even after a “failed” deal, searchers become much more knowledgeable about the potential issues that might arise and have much more confidence in their discussions with business owners.

Summary

Learning about the value and process of QofE is just one of the “known, unknowns” in the search process. Important for a lot of reasons, it must come at the right time to minimize your financial exposure and to take advantage of its value for making decisions and having further discussions based on what is discovered.

The QofE verifies much more than just earnings by providing a wealth of knowledge about the financials of the business you will purchase. The Russian proverb, “trust, but verify” is at the root of this useful tool.

Search on!

Feel free to share some of your own best practices or experiences in dealing with these issues in writing a blog comments. I encourage this dialog, allowing all to learn from both my views and the views of others – a virtuous learning cycle. Jump right in! Also, I frequently update individual blog posts, add to the Reference section and Search tips, so visit the www.jimsteinsharpe.com website regularly.

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2 Comments

  1. RichM on April 20, 2017 at 9:38 am

    This is good advice. The critical issue is showing the seller the numbers as they really are (vs. what the seller believes) via a QoE– you run a substantial risk of the seller walking away as they’ll say: “But these are the numbers as I’ve been running it!” And they are telling truth, somewhat. IMO, the searcher has little power here…

    I recently met with another searcher who completed his search about the same time I did. We both agreed that the biggest issue post-close was unrecorded liabilities($7K in local taxes not paid, $19K software licenses that need renewing, purposely $20K underpaid employees, the list is endless.) It’s not worth chasing these people- you’ve got to move on and build your business.

    The first years’ real cash flow may be as much as 15% lower than the #s you received.

    • Jim Sharpe on April 21, 2017 at 6:39 pm

      Rich, you are not alone in these post closing surprises. You may find that some may break your way. Hard to find any of them in the QofE. Search on! Jim

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