In the world of middle-market mergers and acquisitions (“M&A”), the term “Quality of Earnings,” or “QoE,” holds significant importance for business owners, potential buyers, and other stakeholders. Most business owners are not familiar with QoE reports before exploring a potential M&A transaction, but they should be.
In this article we will delve into Quality of Earnings reports, discuss what they entail, when they occur, who requires them, and why they have become an essential part of middle-market M&A deals.
What is a QoE?
At its most basic level, a QoE report is part of the financial due diligence surrounding a potential M&A transaction. A QoE report is a formal third-party analysis that evaluates the true economic earnings of a company by adjusting the reported earnings for various non-recurring, unusual, or one-time items that may distort the financial performance of the business. It also typically evaluates a company’s compliance with generally accepted accounting principles (“GAAP”) and identifies potential risks associated with an M&A transaction, such as significant customer concentrations and tax compliance matters.
A QoE report is typically conducted by an independent accounting firm with extensive M&A experience. The QoE report evaluates monthly financial data over a “Historical Period” of typically the most recent three (3) fiscal years and trailing-twelve-months (“TTM”). The Historical Period must generally be lengthy enough for the independent accounting firm to identify trends and any “unusual” items captured in the company’s historical financial statements.
In M&A transactions, a business is often valued based on a multiple of its EBITDA (Earnings Before Interest Taxes Depreciation and Amortization); so, being able to determine the true earnings of the business is extremely important! It is not always clear by simply evaluating the business’s historical reported financial statements. That is where a QoE report comes in.
When is a QoE performed?
A QoE is either performed before or during the due diligence process of an M&A transaction. A business owner can engage an independent accounting firm to perform a QoE before potential buyers begin their financial due diligence process in an M&A transaction. This is referred to as a “Sell-Side QoE.” In this case, the business owner bears the cost of the QoE while planning for a potential M&A transaction. A Sell-Side QoE benefits a business owner by validating the company’s earnings before going to market. Having a QoE early in the process promotes a higher level of confidence amongst potential buyers who will be evaluating the business’s financial performance, and it also promotes a higher level of conviction amongst potential buyers as they determine a potential purchase price. Conversely, if there are any “red flags” that come out of the QoE, it is beneficial to identify them early, rather than later in the process when both buyer and seller have already incurred considerable time and money into a deal. If a business owner is represented by an investment banker, the investment banker will likely recommend a Sell-Side QoE.
A potential buyer in a transaction will also typically perform a QoE during the due diligence process of an M&A transaction. This is referred to as a “Buy-Side QoE.” In this case, the potential buyer generally bears the cost of the QoE as part of its financial due diligence. The analysis performed in a QoE is the same whether it is a Sell-Side or Buy-Side QoE; however, if a Sell-Side QoE is performed, a potential buyer and its advisors will typically perform limited procedures to “trust and validate” the Sell-Side QoE during due diligence. If a Sell-Side QoE is not performed, a potential buyer and its advisors will start a Buy-Side QoE from scratch. In this case, the QoE may result in a longer financial due diligence process on a transaction, may identify issues unknown to the seller and their advisors, and may give a potential buyer more leverage to question the company’s financial performance and renegotiate the deal.
Key Benefits of a QoE
Identify or validate adjustments to EBITDA. The QoE will help identify or validate EBITDA add-backs/adjustments to reflect normalized earnings and help a potential buyer analyze the company’s value before transacting.
Address accounting issues. Business owners focus primarily on running and growing their business. Keeping pace with changing and complex accounting standards is a challenge for most businesses. When it comes time for an M&A transaction, accurate financial reporting in accordance with GAAP is critical to for many buyers in determining the value of a business. During a QoE, the company’s financial statements will be analyzed for compliance with GAAP and adjusted accordingly.
Identify risks. Potential buyers are looking for business-specific risks that may affect future earnings. A few of the more common risks that may be identified in a QoE report include customer concentrations, vendor concentrations, and sales/income/use tax compliance to name a few. Identification of business risks may (significantly) impact the valuation of the business, so it’s a key component of a QoE report.
Promotes an efficient transaction. When a potential buyer signs a letter of intent (“LOI”), there is a limited amount of time for the buyer to complete their diligence and decide whether to move forward with a potential transaction. As noted above, having a Sell-Side QoE available can help anticipate the tough questions a buyer will ask. Having the information ready will allow the buyer to progress through their accounting due diligence more efficiently.
Control over the process. Financial due diligence will give a buyer or seller a view of the company’s adjusted EBITDA and insight into how a deal participant may analyze the company’s earnings and key components of the financial statements. If initiated by a seller before going to market, a QoE will allow the seller and its advisors to identify (and potentially address or reframe) potential issues before there are identified by a potential buyer. Buyers will typically highlight QoE adjustments that are favorable to them. By taking the first step with a sell-side QoE, a seller can help ensure that adjustments favorable to the seller are also considered and avoid leaving “chips on the table.”
Credibility and support. A QoE from an experienced independent accounting firm will lend further credibility to a company’s financial statements during a contemplated M&A transaction. A QoE tends to be viewed more favorably than a compiled, reviewed, or audited financial statement, as a QoE can help identify the true earnings capacity of the business, identify potential risks and also provide TTM information. Additionally, the QoE provides more in-depth insight and analysis into the financial statements with the flexibility to focus on key areas and normalize them for things that may (or may not) occur post-transaction. In certain instances, banks will require a QoE for financing purposes instead of compiled, reviewed, or audited financial statements.
Final Thoughts
Overall, Quality of Earnings, or QoE, is a universal concept in M&A transaction that all middle-market business owners should be aware of. Regardless of when a QoE is performed, a potential buyer of a middle-market business will almost of require a QoE. So, it’s important for middle-market business owners to anticipate the need for one when considering an M&A transaction.
If you need further guidance or have any questions on this topic, we are here to help. Explore more and learn about Bonadio’s Investment Banking Services. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
