Quality of Earnings, or “QoE”, is a topic that all middle-market business owners contemplating an M&A transaction should be familiar with. A QoE is a formal third-party analysis performed by an independent accounting firm as part of an M&A transaction that, among other things, 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.
What are the focus areas of a QoE?
During a QoE, the QoE provider obtains and analyzes account-level detail of the company’s historical income statements and balance sheets to identify any potential adjustments to the company’s reported earnings. The QoE provider typically evaluates monthly financial data over a “Historical Period” (typically the most recent three (3) fiscal years and the trailing-twelve-months (“TTM”) period) to identify trends and any “unusual” items captured in the company’s historical financial statements. Key focus areas of a QoE are as follows:
Adjusted EBITDA
The QoE provides an assessment of recurring earnings and historical trends of the company. As part of this assessment, the QoE will calculate the company’s adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). A QoE adjusts reported EBITDA for the following general categories of items:
- Non-Operating Income and Expense. Non-operating income and expense are removed in order to derive adjusted EBITDA. Examples: Investment income/loss; gains/losses on the sale of assets.
- Non-Recurring or Unusual Items. It’s common for companies to experience one-time or unusual transactions that are isolated and otherwise do not occur throughout the normal course of business. Since these items do not contribute to the true recurring earnings of the company, they are removed in order to derive adjusted EBITDA. Examples: One-time legal and professional fees; one-time insurance credits.
- Normalizing Items. Company expenses naturally fluctuate over the historical period. It’s also common for “new, normal” expenses to begin later in the historical period. A QoE adjusts these items to show the effect on EBITDA had they existed consistently, at their current normal rate, over the entire historical period. A “normalizing” adjustment to EBITDA is recorded to “smooth” the expense over the historical period. Examples: Normalizing travel and entertainment expenses over the historical period; normalizing corporate insurance cost over the historical period.
- Out-of-Period Items. It’s also fairly common for private companies to make certain “true-up” accounting adjustments only at year-end. Since a QoE includes an analysis of monthly results, these adjustments typically need to be reallocated to the months to which they relate. Examples: Accrued payroll only adjusted at year-end; other prepaid and expenses only adjusted at year-end.
- Owner Discretionary Items. It’s not unusual for a company to pay for certain personal expenses of the business owner, resulting in “owner-discretionary” expenses being recorded in the company’s income. Since these expenses are outside the normal course of business, and typically not expected to continue post-transaction, a QoE removes them from adjusted EBITDA. Examples: Owner’s personal auto, gas, meals and entertainment, and country club dues; family members on the payroll even though they don’t work for the company.
- GAAP Adjustments. A QoE adjusts the company’s reported EBITDA to ensure that the company’s financial statements are presented in accordance with Generally Accepted Accounting Principles (GAAP). Examples: Revenue recognition adjustments; lease accounting adjustments; cash-to-accrual expense adjustments.
- Pro-Forma Adjustments. Pro-forma adjustments are adjustments to past reported results, as if events that have occurred or are expected to occur took place at the beginning of the historical period. These items are expected to affect EBITDA on a go-forward basis and are adjusted in a QoE. Examples: management’s go-forward compensation, go-forward rent expense, impacts of the loss of significant customers, impacts of significant changes in the cost of raw materials.
Balance Sheet Considerations
A QoE also evaluates the overall quality of the company’s reported balance sheet accounts, primarily focusing on the balance sheet implications of the types of adjustments described above, as well as the assets and liabilities that would ultimately change ownership in an M&A transaction. The QoE identifies potential GAAP adjustments to the balance sheet and investigates historical trends and underlying data to gain comfort that the company’s assets and liabilities are accurately reported over the historical period.
Working Capital
In middle-market deals, buyers almost always structure transactions to be “cash-free, debt-free,” meaning that the seller will walk away with any cash and be responsible for any debt on the balance sheet at closing. A working capital target is normally established prior to closing to define the amount of working capital (current assets minus current liabilities) that the seller needs to deliver to the buyer at closing. This target is typically calculated based on an analysis of adjusted working capital (on a cash-free, debt-free basis and adjusted for QoE findings) over a TTM period. As such, it is essential for the QoE provider to normalize monthly working capital for the types of adjustments described above, as well as seasonal variations, uncollectible receivables, obsolete inventory, changes in deferred revenue and adjustments to prepaid and accrued expenses.
Other Key Risk Areas
A QoE evaluates other key risk areas of a company to identify any unusual trends or areas of concern. Common examples include:
- Revenue. A QoE evaluates revenue over the historical period on a disaggregated basis. Revenue is evaluated by customer, product, end-market, and any other areas relevant to the business. A QoE provider will examine key customer terms. Revenue is evaluated for any significant concentrations, pricing changes, proper recognition in accordance with GAAP, revenue from related parties, and any one-time or non-recurring transactions.
- Vendors. A QoE evaluates purchases by vendor over the historical period to identify any significant concentrations, examine key vendor terms, and evaluate any significant pricing changes.
- Employee Headcount. A QoE evaluates employee headcount over the historical period to identify any gaps that need to be filled, evaluate trends in historical employee turnover rate, and to normalize adjusted EBITDA for compensation and employee related matters.
Proof of Cash
A proof of cash is typically performed in a QoE to validate the company’s historical revenues and expenses. It involves comparing the cash inflows and outflows recorded in the bank statements to the revenue and expenses reported in the company’s financial statements, considering adjustments for accrual-basis accounting. This verification gives potential buyers confidence that the reported earnings are supported by actual cash transactions. The proof of cash also provides buyers with valuable insights into the company’s cash collection cycles and overall financial position.
How does the QoE process impact a business owner?
A QoE process generally takes 45-60 days from start to finish. The QoE provider will typically send the company a comprehensive detailed request list of items needed to complete the QoE. After all the initial requests are met, the QoE provider will analyze the information and request multiple meetings with management to ask questions and dig into the financial trends that they are seeing. A formal written report is published upon completion of the QoE.
A QoE can be a heavy lift for a business owner and his/her accounting team to accommodate. It stresses the importance of clean, organized, and readily available financial records. Because buyers place such a high reliance and importance on the results of the QoE analysis, business owners should be ready to accommodate a QoE to ensure that (a) there are no material adjustments to asserted EBITDA (which may cause buyers to renegotiate the terms of the deal), and (b) the QoE does not delay the overall transaction timeline.
How do the results of a QoE impact a potential M&A transaction?
In most middle-market M&A transactions, transaction value is generally determined based, to a large degree, on a multiple of EBITDA. A buyer’s initial purchase offer is often based on a specified/asserted level of EBITDA, and any changes to EBITDA resulting from the QoE can often lead to significant (negative) adjustments to the purchase price.
To proactively get ahead of any potential “surprises” in a QoE, a business owner should engage their own QoE provider to conduct a QoE before going to market. 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, up-front and in advance of going to market and is often provided to potential buyers to assist in their decision-making process. 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 sell-side QoE, they can be addressed early in the process, before both buyer and seller have incurred considerable time and money into a deal. If a middle-market business owner is represented by an investment banker, the investment banker will likely recommend a sell-side QoE.
Final Thoughts
All middle-market business owners considering a sale of their business should be familiar with QoEs; potential buyers will almost always require one. So, it is important for middle-market business owners to anticipate the need for a QoE and have a basic understanding of what to expect from a QoE when considering an M&A transaction.
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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.
