Numbers are numbers – right? Actually, in business, there are a number of practices ranging from aggressive accounting practices to unintentional external factors that can skew the big-picture.
In M&A, big decisions are made based on the financial value of a company. If those numbers are wrong – everything is jeopardized.
Do you remember when General Electric Co. was the target of an SEC investigation for its creative accounting practices?
It turns out that as much as 25% of its profit in 2016 and 50% of the company’s profit in 2017 was actually an illusion. The company had overstated costs in earlier years so that when accurate financial data was reported in later years, it looked like there was a considerable cost savings.
More often, for SMBs, there’s no criminal intent to defraud investors. But small inaccuracies and incomplete records can still make it difficult to understand the real value of a company’s earnings. I’ve experienced M&A transactions where these little details made a big difference.
Hard Lessons Learned
Shortly after leaving Goldman Sachs, I took on my first middle-market M&A deal. I was armed with years of experience and a solid track record to boost my confidence. As a result, I secured a very favorable deal for our sell-side client and entered into a Letter of Intent (LOI) with a 60-day exclusivity period.
Up to this point – everything seemed to be going smoothly.
As the financial due diligence, the buyer’s QofE, got underway, things began to unravel. The books were not clean. Accounting was a mix of cash-based and accrual-based. When we could find the paperwork we were looking for, the numbers didn’t match up. Assets were overstated and liabilities were barely a footnote in a margin.
The whole deal quickly spiraled into a nightmare as we fought tooth-and-nail to defend the original valuation.
I had made a mistake. I had assumed that the books were well-maintained and that the data provided was reliable.
For years, I had worked deals at Goldman Sachs for enterprise-level companies with well-managed accounting and finance departments. I was wholly unprepared for the dips and turns of the ad-hoc accounting practices that keep things running behind the scenes of smaller businesses.
The truth is – small businesses and founder-owned middle-market companies may not have clean books or solid financial reporting compliance.
That’s where the Quality of Earnings (QofE) assessment comes in.
What is ‘Quality of Earnings’ (QofE) ?
Quality of Earnings – or just simply QofE, is an important step in due diligence. It’s an assessment that aims to identify anomalies and remove conspicuous financial data so that all income can be clearly attributed to either sales or cost savings.
Common QofE adjustments include:
- Discontinued Operations
- Business Activity Unlikely to Repeat
- Transactions at Non-Market Rate
- New Product Acquisition Costs
- Conversion to accrual based accounting
While it’s easy to see some similarities, a QofE is not an audit. An audit typically focuses on verifying business transactions, while a Quality of Earnings assessment aims only to separate certain financial transactions in order to provide a clear view of what’s really happening from an earnings standpoint on a run-rate basis.
Let’s look at the QofE from a case-use perspective.
If a manufacturing company pivoted to produce hand sanitizer and surgical masks at the beginning of 2020 – timed with global product shortages in these areas due to the worldwide global pandemic, there is a good chance that revenue during 2020 and 2021 was dramatically inflated by an operational shift.
In fact, that same manufacturing company might be able to show a three-year history of sustained growth that makes the business look extremely profitable. But when you dig deeper, and learn that revenue was higher due to operations that have since been discontinued, the go-forward earning potential is much lower.
This example, while a little on the nose, highlights exactly why it’s necessary to understand where the money comes from.
Why Sellers Need a QofE
Due diligence is really for the buyers. Collectively, it’s a series of steps taken to verify the legitimacy of how a business is represented during a sale. This process has become increasingly thorough on the buyer’s side, prompting many sellers to proactively conduct a QofE assessment in preparation for a detailed probe from the buyer.
But is it really necessary?
After all – if you’re the seller, this is your company and you’re already familiar with the financials.
Still, conducting a QofE is a necessity. It allows you to control the narrative throughout every stage of the M&A.
Key benefits of a QofE include:
- More Trust with Buyers
- Better Transparency
- More Efficient Due Diligence
- Protects Against a Failed Deal
Conducting a Quality of Earnings Assessment on the sell side is a proactive measure that puts you in a stronger position to negotiate with confidence because you’re not working with rough estimates and best-case-scenario projections. You’re working with real data that has been scrutinized and verified outside of your in-house team.
In this respect, a sell-side QofE puts the founder/owner in the buyer’s shoes. This perspective can help sellers prepare for big questions that come up during negotiations. Knowledge is power in negotiations; the sell-side QofE will put you on equal footing with the buyer, if not at an advantage.
How Much Does a QofE Cost?
A quality of earnings (QofE) analysis is typically conducted by an outside advisory firm, ideally someone with extensive accounting and financial expertise in mergers and acquisitions. Hiring a firm to conduct a QofE provides an unbiased perspective.
But keep in mind that you are not paying for an audit; you are paying for an impartial review of your financial records designed to validate any claims or representations that you make regarding the earning potential of your business.
There are several variables, including the size of the company and the breadth of the QofE that factor into how much this proactive step will cost. A typical price tag falls somewhere between $50-$100k for mid-market businesses.
That might seem like a lot of money, but here’s what you’re paying for:
✔ Accuracy and transparency that builds trust with buyers.
✔ Efficiency that can shorten the due diligence period and accelerate a closed deal.
✔ Data that puts you in a stronger negotiating position.
✔ Preparation that keeps you in a stronger position.
How Embarc Advisors Can Help
At Embarc Advisors, we take a practical approach to the QofE. Instead of racking up weeks or months of billable hours sifting through every detail of your business, we use an 80:20 approach.
We have found that if we focus on substantive issues, like the ones that drive valuation and deal terms, we can spend a lot less time while still delivering high-impact results. In other words, we spend 20% of the time (compared to a typical QofE) and net 80% of the results.
By integrating the QofE with the other financial preparations for the sell-side transaction, we create additional synergies throughout the process. It positions us to more effectively market the opportunity, negotiate a better deal and create better outcomes on key terms such as net working capital.
At Embarc, we offer efficiency that moves you closer to the result you want.
We understand that this essential step feeds directly into financial analysis and modeling, ultimately facilitating the M&A process. So, we look at QofE as a mechanism for building value, enabling us to move faster and bring in more bids to present our clients (you) with a strong selling position.
If you’re looking to sell your business, it can be helpful to conduct a quality of earnings assessment sooner rather than later.
Get in touch with Embarc Advisors and get the process started.