The Value of a Sell Side Quality of Earnings

We’ve long advised that one of the ways to increase the value of your company is to engage a firm to perform a sell-side quality of earnings review. We intuitively knew this to be so but never had the data to prove it. Until now. Read on.

What is a Quality of Earnings Report?

Buyers almost always obtain a quality of earnings report (QoE) as a cornerstone of their due diligence.

Sellers, on the other hand, rarely do.

Unlike an audit that essentially verifies that a company is following Generally Accepted Account Principles (GAAP) and that its income statement and balance sheet accurately portrays its then financial condition, a QoE report shows what the firm’s revenues and earnings are expected to be at the time of closing. So, unlike an audit, a QoE also reflects verified adjustments to the financial statements for items such as excess owner’s compensation, one-time expenses, startup costs for new locations or product lines, and more.

The QoE also adjusts revenues for any regulatory or compliance errors in billing, as well as known – or highly anticipated – changes in reimbursement.

It can also quantify the financial impact of any operational changes deemed necessary immediately post transaction such as changes in staffing levels, wages, or benefits packages, investments in software or infrastructure, etc.So, from a valuation perspective, the QoE is much more important than an audit as it shows the “real” EBITDA the buyer is acquiring at the time of the transaction.

Inherent Conflicts of Interest – The Weaponization of a Quality of Earnings

While no buyer would ever admit it – and understandably so – there is a financial incentive to use the QoE to find shortfalls in EBITDA to secure purchase price reductions post letter of intent. Perhaps even more important, even if this wasn’t the case, the firm engaged to perform the review has the same incentives to challenge earnings in order to win the favor of the buyer and be rewarded with the next QoE assignment.

The Seller’s Defense

But here’s the thing.

When a seller obtains their own QoE report from a reputable third party prior to going to market, they send the message in a not-so-subtle way that, when it comes to aggressively challenging their financial performance, they won’t be “easy pickings.” Moreover, with greater confidence that (a) fewer shortfalls will be found in these already vetted numbers, and (b) that any challenges brought by the buyer will likely be defended vigorously, the energy to use a QoE as a price slashing weapon is substantially diminished. Moreover, when a seller obtains their own QoE, it should not only take less time for the buyer to complete their own (which they will still require), but it can also expedite the collection of certain due diligence items as the seller will already have relevant worksheets and reports at the ready. This may seem relatively minor, but with time being the enemy of all deals, the faster these often-protracted tasks are completed, the less likely some unexpected event or change in buyer sentiment will upend a deal.

Lest we forget, a seller’s QoE can also reveal real issues – often billing related – that can be fixed prior to going to market, thereby preserving EBITDA.

A corollary to the above?

One of the many things we’ve learned over the course of completing nearly 400 deals over 27 years is that, in terms of price cuts, the magnitude is always less when problems are revealed by the seller pre-LOI, than when they are discovered by the buyer post-LOI. So, even if they can’t be easily mitigated, the QoE can also be extremely valuable in identifying, disclosing, and managing gremlins lurking about that can do real damage to your final purchase price.

The Proof: An Increase in the Valuation Multiple

Now we know why a sell-side quality of earnings report can be so valuable. The question, however, is there any proof?

Well, it turns out, now there is.

Over the past two years, GF Data, a firm that analyzes M&A data for transactions below $250 million, has been comparing purchase price multiples for deals where sellers obtained their own QoE report versus those that didn’t.

Across 263 transactions, the nearly half that performed sell-side QoEs sold for an additional half turn multiple of EBITDA (on average) vs. those that didn’t include them.

It might not sound like much, but even for a $5M company with a million in earnings, that half turn converts to an additional $500k in purchase price – an ROI of 900% on a $50k QoE.

Now to be clear, we’re reminded that correlation does not equal causation. Could management teams and firms inclined to get their own review be preternaturally more sophisticated in running their business and thus be more likely to capture higher multiples? We’re sure that some of this comes into play. But here’s what else we know. In our experience, virtually every time one of our clients obtains their own QoE, they find something eminently fixable that, had they not found it, would have sent their multiples plunging. And in these cases, correlation is indeed causation.

In the end, we know that the $30k spent on a QoE report for small, simple operations up to $100k for larger more complex businesses seems like a lot before you even go to market.

After all, “my numbers are solid.”

But trust us when we say that it is extremely rare to come out of due diligence completely unscathed.

So, if you’re a prospective seller, better to recognize the value of a QoE now…than regret it later.

For those of you who are more adventurous, below is an example of how the EBITDA of a company might change from pre-audit, to post-audit, and to post-QoE.