For many owners of private or family-owned businesses, the idea of engaging with an outside firm to dissect, examine, and review every detail of their business’s historical financial records may be daunting. This holds true both for companies that have never been audited or reviewed (or have just begun doing so), and for companies accustomed to having accountants look “under-the-hood”. Regardless of the facts and circumstances around a business’ history, for any owner looking to sell his or her business, preparing a detailed quality of earnings analysis can maximize the value of the business while mitigating surprises that could otherwise emerge during the sale process. 

Quality of earnings (QOE) due diligence is an independent analysis of a company’s financial information. It is a prudent business decision and one that is increasingly performed for sell-side transactions. In recent years, a more intense buy-side process, increasing valuation multiples, and a competitive and efficient market process has led to a rise in sell-side QOE due diligence. An independent QOE report helps private or family-owned businesses preserve their value through a merger and acquisition process, helping to identify potential issues early in the sales process, and accelerating the process once a company is on the market.

Many owners of private or family-owned businesses may not know the QOE review process. Some of the more common questions we hear before beginning a QOE process include:

• Why is this process necessary if we are audited? 
• Won’t an investment banker perform this process for us? 
• Will people find out about the sales process and threaten to leave the company? 
• Who needs to know about your process?
• How much of mine and my team’s time will you need from me during this process? 

We look to address these questions below as well as review some process fundamentals and key points for executives to consider when deciding whether to perform a QOE review.

What value does a QOE report bring to the sell-side process?

The sell side process benefits the seller in several ways before, during, and after a potential buyer comes into the picture, including: 

Preserving or creating value. Most sellers have a very good idea of the minimum price they would agree to with a potential buyer. However, this price may not reflect the true value of their business based on its current operating environment. The sell-side diligence process serves to optimize the seller’s value by quantifying and validating the current EBITDA run-rate of the business, which is used to support a higher purchase price in the market. It is important to avoid only picking up on the “low hanging fruit” in the historical numbers, ensuring that the trends of the business are fully understood and any recent changes in the business are appropriately reflected within the current EBITDA run-rate. Buyers consider sell-side adjustments during their diligence process and they frequently add value to the overall deal transaction. 

Reduces uncertainty. Key issues and trends of the business are identified and discussed upfront as part of any sell-side QOE deliverable, which serves to reduce any red flags a buy-side team would identify during their own diligence process. As part of the process, a sell-side QOE identifies any issues or trends that a buyer will want to ensure they understand. The ability to work through these issues upfront and ensure the trends are properly explained often reduces the risk of an unsuccessful deal. 

Maintain credibility. Frequently, buyers are expecting a sell-side QOE as part of the overall transaction process. This generally indicates the company has taken the process seriously and invested the time and effort to produce a supportable EBITDA run-rate to potential suiters.  Buyers want to trust the party with whom they are entering an agreement, and a sell-side QOE helps that process by ensuring a third-party has taken an unbiased approach to what a normalized EBITDA run-rate has been historically. 

Reduces diligence time. The goal of any sell-side QOE process is to ensure potential suitors have a clear understanding of the specific areas included in a QOE report. The upfront work performed as part of the process also serves to reduce the issues that a buyer needs to resolve as part of their due diligence process.  

Prepares the management team for buy-side diligence. By performing sell-side QOE due diligence, management teams are prepared for the questions and concepts a buy-side diligence team will want to discuss. Having gone through a dry run within the sell-side management meetings helps the team to prepare schedules and analysis that may be important for the buy-side process. 

What is the focus of a sell-side QOE process?  

The sell-side QOE process typically focuses on four main areas: 

Normalized quality of earnings analysis: This involves the quantification of typical areas of adjustments to reported Earnings Before Interest, Taxes and Depreciation and Amortization (EBITDA) in the following main categories: 

• Non-recurring items, e.g., professional fees, gains on settlement, one-time severance. 
• Non-cash items, e.g., stock compensation expense, amortization of up-front payments; that do not match cashflows. 
• Normalization items, e.g., expense run-rates, change of terms. 
• Accounting adjustments e.g., change in accounting policy, purchase accounting adjustments. 
• Pro forma adjustments related to changes in the business that have not been executed yet, e.g. change in customer or vendor terms, change in personnel, cost savings initiatives.

Working capital trending. This involves a review of historical working capital trends on a cash-free, debt-free basis, to establish a view on a potential working capital target or peg for a transaction. 

Key financial and operational trends. This involves a review of historical trends around revenue, gross margin, operating expenses, headcount; and EBITDA margin. This helps to understand the reasons for key financial fluctuations in the company and how these trends may change going forward. 

Debt and debt-like items. This involves a review of potential items a buyer may identify as indebtedness, which may reduce the purchase price. Items such as change of control payments, committed purchases of fixed assets, deferred revenue, and income tax liabilities may be considered as indebtedness as part of any potential transaction.

How is the QOE process different than an audit? 

While an audit is very helpful to the sell-side process to understand historical accounting policies and gain a thorough background of the business, it is very different than the QOE process. The primary differences are: 

• An audit is balance-sheet focused, while a QOE process is income-statement focused. While the QOE process does review balance sheet trends, EBITDA adjustments are primarily generated through a review of income statement accounts. 
• An audit is only concerned with the full fiscal year results, while the QOE process includes a trailing twelve-month (TTM) concept within the scope of review. As such, certain changes in the business may not be reflected within the latest audit report.
• An audit’s level of materiality may be much different than a QOE process. Passed (unrecorded) adjustments need to be understood to determine the potential impact on EBITDA for the historical period under review. 

How will the QOE process impact my business?

Certainly, there is a business to run and key members of the team need to stay focused on their day-to-day roles. As part of the process, onsite meetings with the management team should be as efficient and productive as possible to allow you to run your business without disruption. This is achieved through several actions:  

• Focusing on highest priority requests to send before the meetings. Items like trial balances, sales and margin schedules, and aging schedules are key items that commence the process and prepare for the onsite meetings. In this way, key trends of the business that need to be understood and discussed in-person are easily analyzed and identified in-person. 
• Focusing on material items. Common sense should be used to decide what items are worth following-up on and what items are not worth the time and effort to quantify.  Focusing on material items helps expedite the process while ensuring you are still optimizing your value. 
• Delivering timely schedules. Management should be able to review the findings on a real-time basis and discuss the status of current open items. This allows the company and the deal team to come to agreement on what to explore further and when to take a pass on certain items. 
• Ensuring only appropriate individuals are part of the process. Management should ensure control of the process and decide whom is involved in discussions with the deal team. All requests and questions should be funneled through the appropriate personnel, and all onsite communications should be managed by the company.

Is the seller supported throughout the deal process?

Once the report is delivered, the management team needs support throughout the transaction process. This includes rolling forward EBITDA adjustments to a subsequent period, having discussions with buy-side diligence teams, or working with buy-side teams on setting the working capital target/peg.  

Is there consistency between the work of the QOE review team and the investment bankers work?

The QOE review team should continuously communicate with the seller’s investment bankers on the transaction to ensure information is properly synching with investment bankers’ financial models, and that phrasing or terminology is consistent. The story presented in the QOE review must be aligned with the story presented in any materials prepared by the bankers. The sell-side diligence team is the seller’s advocate during the entire process, both before and after potential buyers are involved. 

What is the ROI on a QOE review?

A seller makes a large financial investment in performing a QOE review. Yet, oftentimes the investment will pay for itself multiple times over in terms of the identification of favorable adjustments and other concepts that would not have been considered otherwise. It is also important to remember that as the process moves forward, any dollars spent on transaction-related expenses (e.g., accounting, legal, bankers, etc.) are considered non-recurring and do not impact any valuation made by a potential buyer. 

Key takeaways

For sellers considering a potential transaction, it is vital to consider how best to prepare your company and management team for a full dive into your financial history. While it may initially be viewed as a daunting process for you and your team, it is oftentimes much more beneficial to discover any unfavorable findings upfront with a team that is on your side, rather than in the middle of the diligence process, where surprises may be lurking behind every corner. 

Remember, no two deals are alike. There are nuances and circumstances in every deal that must be resolved as part of the process. Whether it is a cash-basis of accounting, carving out an entity, or understanding an expected change in leadership post-transaction, the ability to identify and get ahead of these issues as soon as possible is important for any seller who wants to maximize the value of their business.