Quality of Earnings: the Cheat Code for Due Diligence

We’ve seen it time and time again during the due diligence phase of M&A negotiations–the timeline lengthens, and buyer-seller disputes increase when all the fine details are brought to light, leading to a higher likelihood of a deal falling through.  In nearly all deals these days, the buyer will engage a third party to perform a Quality of Earnings (“QoE”) analysis – and this is where things usually get spicy. That third party is likely to uncover a range of issues that had not previously surfaced in discussions, which invariably leads to some challenging discussions and potentially repricing the deal.   

One way to get ahead of this type of issue is to engage in a QoE analysis prior to going to market – a so-called “Sell-side QoE.” Having a QoE performed prior to going to market significantly streamlines the due diligence process and increases the chance that both sides of the table are satisfied with the outcome. However, many business owners are unaware of all the factors that go into a QoE analysis and how having one performed can help maximize sale value and shorten the deal timeline. 

What does Quality of Earnings mean? 

Simply defined, Quality of Earnings refers to an assessment of a company’s earnings that removes any bias or inaccuracies introduced by unreliable accounting methods to more accurately illustrate its operational efficiency. 

A fundamental aspect of a Quality of Earnings (QoE) report is that it strictly adheres to the most up-to-date Generally Accepted Accounting Principles (GAAP). The final QoE report provides a detailed analysis of a company’s revenue, expenses, and normalized earnings and summarizes any findings or recommendations from the analysis.  

What Info is Needed: 

A QoE report is designed to help both sides understand how much net working capital is needed to run the business and identifies a point in time that they may need to invest additional capital to maintain or further operations. 

In order to complete the QoE report, you may be required to provide the following information: 

• Financial statements 
• Supporting schedules 
• General ledger 
• Tax returns 
• Management accounts 
• Sales contracts 
• Vendor contracts 
• Board minutes and presentations 
• Industry research and analysis 

What’s Included? 

It’s important to remember that a quality of earnings analysis is not an audit, so no opinion is included in the report. A typical QoE report is formatted as a large Excel data document (aka a “databook”), sometimes including a PDF summary attachment. 

Every QoE report is different, but generally, you can expect the following sections in a finished QoE report: 

• Executive Report 
• Financial Statements 
• Account Analysis 

What do Buyers Want to See in a QoE Report?

Proof of Cash: Proof of Cash is just like it sounds. The seller’s financial statements should accurately reflect the actual cash collected and disbursed by the company. For companies on an accrual accounting basis, this means following revenues and expenses through and tying your financial statements out to cash accounts.   

Working Capital Analysis: How much money does it take actually to run the company? The Working Capital analysis should set an “adequate working capital” level to operate the business. Working capital analysis is in many cases controversial and open to negotiation both at the LOI stage and throughout QoE / diligence.   

Adjusted EBITDA: Adjusted EBITDA represents the business’s earnings after adjusting for non-operational and non-recurring costs, utilizing accounting principle-based adjustments and normalizations. Adjusted EBITDA is probably the most critical metric during due diligence and requires a deep dive into the Profit and Loss statement and Balance Sheet accounts. 

QoE Benefits for Sellers: 

In today’s deal environment, the best practice is for sellers to engage a specialist to perform this analysis before going to market. Here are some benefits of having a QoE analysis performed for the seller: 

Validates your Adjustments & Add-Backs

The QoE report should reflect normalized earnings. If any additional evidence is needed to back up the reasoning behind an adjustment– you can present it here. 

Speeds up the Deal Timeline

After the 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 or leave the deal on the table. Conducting a sell-side QoE analysis can help a seller anticipate most questions a buyer would ask. Having the information ahead of time allows the buyer to progress through their accounting due diligence more efficiently. 

Boosts Purchase Price

Remaining surefooted is the best way for a seller to maintain some control during the diligence process, as the findings of due diligence whittle a final selling price down. During diligence, Buyers will generally emphasize adjustments that are favorable to them. A thorough QoE report allows a seller to pre-emptively address diligence issues and ensures that adjustments favorable to them are still considered, and avoids leaving “chips on the table.” 

Provides Credibility

A thorough Quality of Earnings analysis performed by an experienced third party validates your financial statements, especially if those statements are not audited. Additionally, your QofE report provides in-depth insight into your company’s key areas. This allows the seller to highlight unique differentiators that might go unnoticed during standard buyer due diligence. 

Relieves Pressure on Internal Team

During a transaction, the seller’s in-house financial and accounting team might need to respond quickly to due diligence inquiries and document requests. Finding the bandwidth to do so, in addition to performing their day-to-day work, can be impossible and can lead to delays. Having a QoE report performed by an independent firm will limit distractions and delays for your team, allowing them to continue their work. 

Who is Involved in a QoE? 

Generally, Conducting a Quality of Earnings analysis requires input from a few critical stakeholders, including: 

• The business owner or CEO 
• An M&A advisor or investment banker 
• An accountant or financial analyst 
• An M&A lawyer 
• A tax specialist 

However, all QoE reports are different. Depending on your company’s complexity, you may need to include some specialized stakeholders (industry experts, HR management, IT specialists, etc.). 

Quality of Earnings, Summed Up: 

Sellers, through their M&A advisors and investment bankers, are realizing that they can increase deal value, speed up the diligence process, validate their adjustments and add-backs, and gain critical support by getting a Quality of Earnings Analysis conducted on their company. 

A QoE report from a reputable firm provides both the buyer and the seller with a more accurate and holistic view of a company’s financial health, outlines potential risks, and enables investors to make informed investment decisions.  

Our sell-side M&A Advisory team helps our clients lead transactions while also acting as valuation experts and value growth advisors. Our passion for working with CEO Founders has allowed us to perfect our advisory process. Quantive has successfully executed over 150+ transactions–get in touch with our expert advisory team today to get started.