Sell-side Due Diligence: Focus on Your Needs with a Quality of Earnings Report

When it comes to selling your company, an audit or review of your financial statements is simply not enough. Rather, focusing on EBITDA, income and working capital – not to mention add-backs or deductions that may adjust your EBIDTA – provides a clearer, more accurate understanding of what your business is worth. And, it all starts with a Quality of Earnings (QofE) Report.

What on earth is a Quality of Earnings Report?

A QofE, while similar to an audit, is less focused on checking items off a list or following specific standards from governing boards. We all know how satisfying it can be to check a task off your list, but the ability to customize areas of focus and zero in on the most critical parts of a business are what set a QofE apart.

A QofE focuses more on the needs of the specific business and doesn’t cover those unnecessary facts and figures that won’t help you sell your business and provide value to the user of the report. A QofE, as it sounds, is focused on the earnings of your company and income, whereas a typical audit concentrates mainly on the balance sheet. Throughout a QofE, our goal is to identify any nonrecurring income or expenses of the company to determine a stabilized, normalized EBITDA that a potential buyer can use to evaluate the value of a business.

Why Should I Conduct a Quality of Earnings Report?

On the sell-side of a transaction, a QofE is an ideal tool to prepare a company for sale. As you’re going through the process, a sell-side QofE is helpful because it primes you for when a buyer shows interest in understanding what your normalized level of earnings are. A sell-side QofE can offer us a lot in terms of lending credibility to the numbers that would either be included in an investment banking information memorandum or in the event that a buyer approaches you directly. It is also an important step to making sure there are no skeletons in the closet or other unwanted surprises prior to going to market.

Additionally, the report helps show a buyer that you’re serious about going to market. It tells them you’ve invested the time, energy and money in identifying credible, normalized numbers and an accurate representation of what your business operations generate.

Don’t worry, we didn’t forget about the buyer! Over on the buy-side, the goal of the report is to identify any red flags or information you don’t know about the company that might prevent you from acquiring or possibly change your opinion about the earnings and cashflow that you expected to receive from the company.

QofE reports are independent and performed by advisors like us, so the seller and buyer can obtain nonbiased, credible information about the financial performance of the business. No frills, no exaggerations, no nonsense.

Preparing to Sell? Conduct a QofE Now

I always encourage business owners, who are preparing to sell their company, to perform a QofE ASAP. Taking this vital step early in the process can reduce the amount of time a buyer needs to spend evaluating the seller’s financials. And we all love saving time. By starting the negotiation process with this information on hand, buyers and sellers can have informed, constructive conversations about the value of the business. Buyers can ask questions, to which a seller or your advisor is more likely to have the answers, when armed with a QofE.

If a buyer is already at the table and a QofE has not yet been performed, a sell-side QofE can be conducted with the buyer’s diligence. The seller can utilize this same report if the transaction were to fall through as well. Meaning, it’s still money well spent to have a QofE done, as that report can provide other potential buyers with valuable data.

How Long Does the QofE Process Take?

As the saying goes, time kills all deals. When a seller or buyer is motivated to complete the transaction and financials are in order, the entire process can take roughly four to five weeks. A smooth and successful report starts with your buy-in and time commitment to provide the information and answers an advisor needs. Our next section gives a breakdown of what to prepare, for those sellers sweating while reading this, when you realize your financials might not be in perfect order.

What Can You Do Early on to Prepare?

When prepping for a transaction, organize your historical documents and make sure you’re keeping up with your current accounting. This includes everything from your tax returns to reviewed, compiled or audited financials. Make sure this is all in a centralized database so that when the information is requested for the QofE, you’re ready to go.

Are there Red Flags to Look For During This Stage?

Sometimes a seller or buyer doesn’t have experience with transactions. There will often be, as a result, confusion around working capital. And that’s okay! To provide an explanation, the working capital of a business is typically identified as current assets less current liabilities. For current assets, you’re primarily looking at receivables, inventory and prepaids – and for current liabilities, you’re reviewing accounts payable, accrued expenses and customer deposits. A buyer looking at a business and proposing a purchase price will typically include the assumption that the business will be sold with a “normal” level of working capital in that proposal.

Sellers, in these instances, sometimes think that the sale of the company will provide proceeds equal to the amount of the purchase price plus receivables. That is not necessarily the case, as you, the seller, don’t retain receivables or inventories in most transactions. As a result, it’s occasionally difficult to match the expectations of the seller with the expectations of the buyer when it comes to working capital. Enter the sell-side QofE, where a seller or buyer can add value and present a working capital target that the company can rely on for what you need to leave in the business to allow the buyer to have efficient operations after a transaction.

What Mistakes Can You Avoid in the Quality of Earnings Process?

When we start the QofE process, if there are significant or overly aggressive add-backs, it can make us skeptical of the financials as a whole. This can also cause the report to take longer, as we’ll want to dig even deeper into the financials. With that said, if you do have personal or discretionary expenses running through your business, you want to identify those and make sure they’re organized. This helps your diligence team verify them and include them as add-backs, since personal or discretionary expenses are often not incurred by a new buyer and should not be factored into the company’s normalized earnings or valuation.

Ready For the Next Step?

Sikich’s transaction advisors have deep experience supporting sellers and buyers during the critical process of a QofE report. If you want to make sure the due diligence performed is done right, contact us today to learn more.