This month we checked in with our colleague, John O'Dore of Chinook Capital Advisors to discuss Quality Earnings Reports and their value in your overall financial picture.
by John O'Dore, Chinook Capital Advisors
You’ve owned your business for years, possibly even decades. You’ve built it into an enterprise you’re proud of, and you believe it has a bright future. However, you’ve never had a need for reviewed or audited financial statements. Why would you? After all, you file your taxes and turn an impressive profit. However, now that you’re considering a sale, you realize your finances need a little work before they’re ready for the scrutiny of third-party buyers. A complicated trail of owner-related adjustments needs explanation too. Your M&A advisor or CPA might recommend reviewed or audited financials. However, a popular alternative accepted by many buyers and banks is available: a Quality of Earnings Report or “QofE”.
What is a QofE?
A QofE is an independent analysis primarily focused on the quality of your income statement and adjusted EBITDA (earnings before interest, taxes, depreciation and amortization). A potential buyer will have value in a QofE for a couple of reasons:
1. To quantify true earnings of the underlying business; and
2. To verify the reasonableness of “add backs” added to the earnings by the seller in order to properly represent future profits the new owner can expect.
When preparing the QofE, the CPA firm may find or make recommendations related to:
· Revenue or expenses accounted for in an incorrect period
· Improper accounting methodologies
· Discontinued operations
· Open employee or shareholder positions
· Missing expenses
· Improper or additional add-backs
· Pro-forma adjustments
· Tax exposures (especially complex state and local tax issues)
· Tax strategies related to the transaction (for example, 338(h)(10) election strategies or purchase price allocation strategies related to personal goodwill, non-completes and/or depreciation)
Identifying one or more such issues during the final due diligence phase is likely to give the seller a major headache and could change the LOI terms. That’s bad news for the seller. A QofE report tends to be less expensive and intrusive than a full audit and will contribute to maximize the business’s value, making it a prudent investment. The QofE enables the owner to present the company’s most accurate financial picture. This allows the following to be addressed before due diligence:
· Non-GAAP (generally accepted accounting principles) issues
· Revenue recognition issues and accrual accounting issues
· Financial reporting issues
· Anomalies in the numbers
· Non-recurring adjustments and one-off events
· Working capital issues and the calculation of normal working capital levels
· Tax and accounting compliance issues
As you can imagine, the valuation agreed to in the letter of intent (LOI) could be subject to renegotiation if the buyer discovers these during due diligence. Done beforehand, with time to address any accounting nuances, you will be able to anticipate potential problems, prepare answers and plan corrective actions. This will give you a real advantage if the buyer tries to raise issues down the road.
Just a reminder – due diligence should be a verification process and not a discovery process.
Key goals of the due diligence process: speed and value.
A business owner engaging in a sale transaction with a QofE in place is assured a better experience than one without. Ultimately, once the right buyer is identified, owners in due diligence are focused on closing a deal quickly while maximizing value. After the LOI is signed, the due diligence process and timing may vary based on whether a QofE is present. Without it, the buyer may hire their own accounting firm to scrutinize your financial statements and internal controls. This can add 6 to 8 weeks to the closing process. Let us remind you: there is an inverse relationship between sale price and the duration of the due diligence phase.
Fundamentally, transactions are about trust.
A prudent buyer is not going to believe everything they have been told about the business and EBITDA adjustments prior to due diligence. A QofE provides a professional, third-party analysis by a reputable CPA firm that validates the financial information an owner has shared about the business. Here’s the bottom line: an owner is well advised to have a CPA firm help with financial due diligence and a review of controls early in the sale preparation process. You’ve saved money for years not having your financials reviewed. It’s time to invest in proper financial due diligence prior to the sale.
Distrust kills deals.
Trust closes deals.
Have questions about how QofE can benefit your business? Contact John O'Dore at john@chinookadvisors.com.