Search funds have limited resources. One of the frequent questions we get from searchers is about how much a Quality of Earnings (QoE) report costs and how we structure the arrangement in the event of a broken deal. At Hood & Strong LLP, we’ve been in the search fund community since 2004 and understand how the search fund model works. We want to share with you some ideas we learned over time on how to structure, manage, and even shift the burden of cost to the seller, while getting the most value out of your accountant.
Defining the scope of work
The scope of work on the financial due diligence drives the cost, but there is no uniform standard scope or presentation for due diligence report in the accounting industry. The quality of earnings is a part of financial due diligence that should be very focused on key areas of the business, and agreed upon between the searcher and accountant, so not to waste time and effort on matters that are not significant and non-conducive to evaluating the performance and financial position of the business.
Not only should a focused quality of earnings report provide cost savings to the searcher, it should clearly and succinctly present significant findings and recommendations, provide relevant perspective on key earning components and adjustments, and a set of adjusted and pro forma financial statements that include income statements and balance sheet as expected by the lenders and investors in the community. There may be various factors that impact the costs, but for the typical search fund targets, our cost of a quality of earnings report runs about $20,000 to $30,000, and include the standard package of a quality of earnings analysis, working capital analysis, limited tax diligence and adjusted financial statements.
Risk sharing arrangement on broken deals
It is standard for accountants that practice M&A due diligence to offer a deferral on fee payment until the deal is closed. In addition to fee deferral, accountants in the search fund community should also be able to structure a risk sharing arrangement with the searcher whereby the fees are adjusted for broken deals or rolled over to a future deal. You should talk to your accountant about the specifics of the arrangement. Nonetheless, both are attractive options for a searcher that is working with limited resources, and also speak to the underlying experience and confidence the accountant has in the search fund model and the searcher.
When to contact and engage your accountant
Often times the searchers contact us after an LOI is signed. Jim Stein Sharpe wrote a very informative article about, and explaining, the quality of earnings process, where he cautions on starting the accounting diligence too early. We generally agree with Jim’s view on this. But to expand and clarify our perspective, we think it is never too early for the searcher to contact us. When you are drafting the letter of intent and contemplating the important terms, you should use your accountant as a resource. A good accountant should have a deep breadth of experience in the business and industry to weigh in with feedback and point to pitfalls, and provide you with a relevant perspective, such as how to think about the working capital and its impact to overall valuation of the company, and how structure the NWC peg accordingly. The accountant should also provide the seller’s perspective and anticipate seller’s push back on significant terms such as the implication of an asset versus stock deal that may require making the seller whole.
We encourage the searchers to contact us early even before engaging us on the due diligence. We enjoy talking about the deals and be a sounding board. We don’t charge by the hour for the questions we get, unless the questions require significant amount of work or research, which, of course, we would let you know. Sometimes through our early discussions, we may be able to help set the focus and identify potential key areas of concern before anyone gets too invested.
Managing the cost by structuring in phases
There may be times when we may need to get involved as soon as the LOI is signed and before the searcher has performed some level of diligence on his or her own. A situation where our engagement may be necessary so early is when the searcher has low confidence on the company's reported EBITDA due to cash basis reporting (consider a software company with a subscription model where there should be unearned revenue.)
In those situations, we recommend managing the cost by structuring a multi-phase process for the financial due diligence. First phase of the work includes scrubbing the numbers, identify adjustments and determine a preliminary TTM adjusted EBITDA. During this phase, we also identify the areas of potential significant issues. To begin, we typically just need the basic information of a CIM, LOI, financial statements for the trail twelve months, etc. The cost of phase one is a small fraction of the overall costs, and helps the searcher to minimize and manage the costs.
If everything still looks good after phase one and the searcher wants to proceed with the transaction, then we begin the second phase to complete the full diligence of historical EBITDA, adjusted financials, working capital analysis, tax diligence, etc.
Better yet, seller paying for the quality of earnings analysis!
In certain situations where the seller is really motivated to sell, or is demanding a hefty price for the business, or the buyer is on the fence on the deal, there may be an opportunity push the seller to bear the cost of performing a quality of earnings analysis. We have successfully helped advised our clients to use this strategy and convince the sellers to perform sell-side due diligence. The key considerations and benefits for the seller is to help the seller prepare for the sale, increase the chance of a successful deal and maximize the sale price. If there are issues in the company, the seller would want to know about them and resolve them early. To incentivize the seller to pay for the due diligence upfront, the buyer can reimburse the seller upon a successful close. Even if the deal doesn’t close, the seller can keep and use the report for the next buyer. If the seller wants to sell, is confident in the business and its earnings, there is really no reason not to do it. If negotiated properly and successfully, it is a win-win for all parties.
I am curious to get your feedback, thoughts and questions, and would be happy to have a dialogue with you and learn where you are in your search process.