A quality of earnings report, or a QoE for short, is an effective tool for preparing your business for a sale. Think of it as similar to an inspection before you buy a car or a house. A buyer of a business often requires the QoE to finalize the valuation of the deal as well as submit it to the lender to obtain financing.
How can a business owner benefit?
The business owner can also greatly benefit from obtaining a QoE in order to understand what kind of value they can get in the market. Once a QoE is completed, the business owner working with their financial representative can use it to market and tell the story of the business through the numbers. When a QoE is performed before the business is marketed, it becomes a tool for prospective buyers to evaluate the business and, upon the signing of an offer, becomes the road map to performing an efficient buy-side due diligence process.
As the old adage goes, “time kills all deals”. Having a QoE in your pocket can not only help you understand the value of your business and give you strategies for negotiation, but it can also save you a lot of time, confusion, and headache in the process. Below are some frequently asked questions about QoE’s.
What are typically the key components that go into a QoE?
1. Calculating adjusted EBITDA
The QoE starts by calculating adjusted EBITDA for the past few years as well as the trailing twelve months of the business.
EBITDA stands for earnings before interest, taxes, depreciation and amortization. Valuation of most businesses, except for those in technology and software, is typically based on a multiple of EBITDA.
Next, we would calculate normalizing adjustments to EBITDA. This consists of sellers’ compensation, discretionary expenses, non-recurring expenses as well as any other one-off transactions. These are all positive aspects for a seller to adjust for because they are called “addbacks” and would increase EBITDA. On the flip side too, though, we would also want to decrease EBITDA for items of this nature on the revenue/income side, i.e. looking for discretionary and non-recurring income.
Ultimately the adjusted EBITDA number represents what a buyer would expect to be their operating profits when they take over the business. As a result, the buyer pays the seller a multiple on the EBITDA.
2. Documenting the operating assets and liabilities of a transaction
The second item that typically goes into a QoE is documenting the nature of the operating assets and liabilities that will go in a transaction, which is typically a sale of assets on a cash free, debt free basis. The analyst would determine what assets and liabilities are operating versus non-operating. This exercise is important because the purchase agreement schedules contemplate the assets acquired and liabilities assumed.
3. Net working capital analysis
The third item we focus on is the net working capital (NWC) analysis. At the end of the day, the business owner gets back their cash in the business bank account but the total cash consideration is usually subject to a net working capital true up mechanism. The NWC true up mechanism, also known as the net working capital peg, determines how much net working capital is needed to fund the business so that ultimately after settlement, the seller will either get a check back for a NWC excess or they have to cut a check back to the buyer for a NWC deficit.
Here, the QoE will prepare the business owner for how to negotiate the NWC peg and to not get hit with a NWC deficit surprise down the road.
What are the pitfalls business owners encounter when they don’t obtain a QoE?
A lot of business owners lose on value because they are not considering the entire universe of addbacks they could apply to their EBITDA. I’ve seen many deals, brought to me by buyers, that don’t have an associated seller QoE. Oftentimes, the EBITDA proposed by the buyer is much lower than it could be shown after a thorough QoE analysis.
On the flip side, there are business owners who calculated their business’s EBITDA too high because they added back items that are not acceptable. For example, balance sheet “addbacks” are not acceptable, because an addback to EBITDA applies only to discretionary and non-recurring expenses. I have seen business owners who, due to this error, have been disappointed in their resulting valuation.
What does a business owner need to do to have a successful QoE?
Having financials that follow good accounting methods, especially being on an accrual basis of accounting, would help the QoE process become more successful.