If your business has an enterprise value of $10- million or more, it’s a good idea to get a quality of earnings report before putting your business on the market. A quality of earning (QoE) report reviews the earning power of the business to determine those earnings are accurate and sustainable.
Kind of like getting a pre-inspection on your house before putting it on the market, a sell-side QoE report is designed to uncover any questionable positions or discrepancies in your accounting system. Buyers will routinely conduct a QoE report as part of their due diligence, but there’s a growing trend that sellers in the lower middle market will come to the table with a QoE of their own.
Many business owners do not capture their financials according to standard industry norms. A QoE digs into your records to ensure that your numbers are still accurate and verifiable when under the microscope by both potential acquirers and their lenders.
Having a sell-side QoE done as part of your marketing package provides buyers assurances that your financials are organized and vetted. This may give you a leg up in the process and could attract more buyers or net you a higher value.
Imagine a buyer has reviewed a business’s information and offered a six-multiple on EBITDA (earnings before interest taxes, depreciation, and amortization) in their initial letter of intent (LOI). Unfortunately, the seller doesn’t have good financials that have been tested and scrutinized by an outside party. Once the buyer vets the financials, they uncover some adjustments to EBITDA they don’t agree with or that revenue/expenses were accounted in the wrong period.
Now the buyer is still offering a six-multiple, but as they calculate it, the EBITDA is at $3.3 million, not the $3.8 million originally presented. That $500,000 difference, times six, becomes a $3 million adjustment on the valuation, or as we call it in the industry, a “haircut.”
That kind of news is no fun for anyone. The seller is unhappy, but oftentimes so is the buyer. No one likes surprises. With that kind of valuation shift, the seller may walk away from the deal, but buyers might walk, too. They may decide the deal no longer fits their parameters, or they may be too suspicious of the seller’s trustworthiness and intent to continue with the deal.
If the deal dies in due diligence, the buyer is out a lot of time and money and has to start over to meet their acquisition goals. That’s why buyers like to see a quality of earnings report. It means fewer surprises and less risk as they move through the process. Less risk means better chance of successfully closing the deal.
With your numbers adjusted and verified in a QoE report, you could discover that it doesn’t make sense to sell. What looked good to you using your own bookkeeping methods might fall short of expectations when refactored and adjusted per industry norms. As a seller, it’s better to have that information early on. You may decide to make changes before your business goes to market. If not, present that story proactively to buyers.
It’s often said, “Go ugly early.” Present a problem up front to maintain the buyer’s trust and ensure you’re negotiating with people who are the right fit for your business.
Time kills all deals, but a quality of earnings report keeps the due diligence process moving efficiently. In a clear case of “trust but verify,” buyers will still run their own QoE analysis. That said, the information in your sell-side report will make that process faster and easier.
Getting a quality of earnings report does take some investment, but the business owner is likely to get a good return.
Buyers often say they will pay more for a company with a QoE report. Because, again, it lowers the buyer’s risk. If you have your numbers evaluated and vetted, you can go into the deal feeling more confident that the numbers presented in an LOI will be the number at the closing table.
If you’re planning on selling your business, you can’t over-prepare. Investing in a credible QoE can significantly help a company’s marketability, valuation, and the likelihood it will sell, all while shortening the overall process through negotiation and due diligence.
Scott Bushkie is principal of Cornerstone Business Services.