What? Why? When? How? Who?

What is a Quality of Earnings report?

Quality of Earnings (QOE) represents the most accurate representation of a seller’s true earnings by looking at a company’s historical revenue, earnings, and adjusted EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization). Historically, this will include normalizing revenues and expenses that are either non-recurring or not part of future operations. Other areas of focus include concentrations of risk from significant customer relationships, vendors, safety, information technology, environmental, insurance, key employees, and benefits. QOE will also consider future earnings as it relates to external drivers of the business, backlog and pipeline.

A QOE report also analyzes trends, fluctuations and variances month-over-month, analyzing the drivers that decrease or increase revenues, costs and margin. QOE will analyze business data, financial data and general ledger accounts that would not be readily apparent from internally prepared financial statements.

Why conduct Quality of Earnings analysis?

As you navigate the process of selling your company, the buyer is almost certainly going to engage a third-party firm to conduct QOE.  The investment banker on your team needs to understand your business better than the buyer’s firm. Being pro-active in negotiating price and terms is critical, holding price and terms from Letter of Intent through closing.  Diligent preparation and planning are critical to maximizing value and terms. Even if the business has annual reviewed or audited financial statements by a third-party CPA, the company should still plan for sell-side QOE prepared in advance of going to market. Auditors are focusing on whether the financial statements are presented fairly, while QOE normalizes and adjusts financial statements to more accurately reflect ongoing operations.

When should Quality of Earnings work be performed?

QOE should be one of the first steps you take when preparing your company to sell as it can identify potential problem areas before your company goes to market and allows sufficient time for management to make the necessary corrective actions. A seller’s primary objective is typically to maximize price and terms and QOE is an essential step to ensuring your business transacts for the highest price and with the most favorable and protective terms for the owners of the business.

The alternative is a buyer identifying numerous issues late in the process during the buyer’s due diligence process that was not previously disclosed, leading to renegotiation of price and terms (re-trading the transaction). Frequent deal issues uncovered in buyer’s QOE include insufficient or inaccurate financial records, errors in data, unrecorded liabilities, inaccurate inventory, uncollectible receivables, inconsistent accounting policies and changes in accounting methodologies, all of which could lead to re-trading if disclosed too late.

How should Quality of Earnings be performed?

ClearRidge has the training, talent and experience to perform QOE work for their sell-side clients in-house. If QOE were to be outsourced, the seller is left with an advisor who is trying to interpret the work of another firm that is no longer part of the process. The seller’s advisor would have neither the knowledge nor understanding of the data to support their position, defend or iterate on the data if required; instead relying on the work of others no longer engaged in discussions with the buyer. From the buyer’s perspective, a buyer will always engage their own independent QOE firm later in the sale process and that firm typically engages directly with the buyer’s and seller’s teams. To deliver the best outcome, the seller’s M&A advisor needs to be at the heart of the diligence and QOE process.

Who performs the Quality of Earnings analysis?

There are many reasons you need to find an Investment Banking firm that has the training, experience, accreditation and capability to do this work in-house:

• Understanding the data: the author of the Quality of Earnings report understands the business and is in the best position to counter any arguments put forth by the third-party QOE firm hired by the buyer.
• Due diligence preparation: the data for the Quality of Earnings needs to be available for due diligence and it saves a business owner time and money if the same provider of QOE populates the dataroom and manages the diligence process.
• Defensible EBITDA: with expert knowledge and experience in QOE work, an experienced investment banker can defend the EBITDA of the business and allows less room for the buyer’s QOE firm to renegotiate price and terms (re-trading the transaction).
• Credibility: the buyer’s team quickly learns they have less opportunity to re-trade the deal if they are negotiating against the firm that performed the QOE.
• Head start: if you perform QOE in the preparation phase, in advance of any discussions with a buyer, you reduce the time spent in due diligence. You’re also less likely to encounter surprises in diligence that can derail a transaction.
• Access to buyers: The best strategic buyers screen deals from investment banks in which they have the most confidence. Solid, dependable data from a reliable and credible investment banker opens up a deal to the best buyers.

 

Image from freepik. Tulsa Oklahoma Mergers Acquisitions Investment Banking Transaction Advisors Sell-Side M&A.