Quality of Earnings - a Must or Nice-to-Have for Peace of Mind
May 11, 2023
by a searcher from Yale University - School of Management in Boston, MA, USA
How to best think about the need for a QoE? Is the size of the transaction the deciding factor or the complexity of a business's financials? If the lender does not require it, when would you want to get it done, especially for a smaller transaction (i.e., <$1.5M)? It would be great to hear from those who did it and discovered something that truly made it worthwhile.
from University of Tennessee in Nashville, TN, USA
There are several benefits to having a QoE performed during diligence.
1. QoEs are a good tool to gain accurate insight into the normalization of business activity over a period of time. Many times Sellers and advisors present their addbacks to EBITDA. These include management assertions that certain expenses are one-time, non-recurring. A QoE can help validate management's assertions.
2. QoEs are a good tool to convert cash-basis accounting presentation into accrual-basis presentation. The biggest issue here occurs relative to period reporting timing differences. Collections on outstanding receivables are often received in future periods. Under cash-basis, these revenues are recorded when received and not when earned. QoEs recast the financials and align revenues and expenses within the correct period in which the activity occurred.
3. QoEs are a good tool to understand the revenue streams that make-up an organization. Many companies have multiple revenue channels. These revenue channels each have their own risk profiles. By understanding ahead of time the companies revenue makeup with hard numbers, a Buyer gets the added benefit of strategic planning for growth earlier in the process.
4. QoEs are a good tool to identify Net Working Capital (NWC) targets within an organization and aid in negotiations. As part of a standard engagement, the QoE also recasts the balance sheet in an accrual-basis presentation. For NWC, specifically, debt and debt-like accounts are removed from the calculation to allow a truer picture of what has been required historically to operate the business. Since the third-party is responsible for compiling the financial information provided by the Seller, there is little room for large Buyer-Seller disagreement on the topic.
5. QoEs are a good tool to reassure lenders and investors that they are funding a business that aligns with what was presented to them. For SBA lending, this may not matter much since personal guarantees are mandatory. Our PE firm (when I was corporate) required a QoE for any target that had an EBITDA of $2M+. The risk on smaller deals is lower since there is less is usually lower dollar amounts involved and the added benefit may not be worth the additional transaction costs.
6. QoEs are a good tool to keep Buyers from making multi-million dollar mistakes. I have been a party to a $62M transaction where the Seller and advisor claimed EBITDA of just north of $5M. The company had audited financial statements. The QoE determined that the actual trailing twelve months (TTM) EBITDA was less than $1M and that the company had never had EBITDA north of $3M in the prior three years. The QoE was effective in reframing the transaction for all parties because of the nature of the recurring revenues generated by the assets our company was acquiring.
QoEs are not intended for every transaction. Size and risk thresholds will determine whether a QoE is the right option for a Buyer. However, for $10-$15K, I believe that the expenditure is of significant value beyond its cost.
from Tulane University in Portland, ME, USA
A key part in these smaller deals is actually the proof of cash, a different arm of financial due diligence in which a consultant matches the company’s financial statements with their third party bank statements to validate that the cash inflows and outflows match the financial statements at a high level.
A quality of earnings is important to validate that the earnings potential of the business is accurate to your valuation and assumptions. Even a “lite” QoE is worthwhile for any size deal
That being said, the procedures and deliverables should match the needs of the deal and unfortunately all too often providers go overboard to bill more, another issue my firm aims to fix