In recent years, quality of earnings reports (Q of E report), have become more popular in M&A deals. Whether the seller’s financials are audited, reviewed, compiled, in QuickBooks, or on the back of a napkin, a quality of earnings report helps buyers become more comfortable with the seller’s numbers and identifies risks in the business. Until recently, these reports were mostly completed for larger deals, but lately, they have been performed for companies at $10 million in revenue or below. The reports are performed by a third-party accounting firm, and usually take a few weeks to complete.
Q of E reports is almost standard for all public and private-equity buyers for deals above $50 million. This is to provide a third-party analysis and review of the seller’s financials and the structure of the deal. Third parties are independent and have no stake in the game, so they are generally unbiased and not influenced by any pressure to do a deal. Public company boards of directors and private equity investors typically insist on getting these reports, not only for their independent analysis but also to provide another perspective on the deal that the buyers may have missed and to mitigate liability if an acquisition turns out to be unfavorable.
The Q of E provides analysis into the quality of earnings—that is, how sustainable are revenues and earnings and how realistic are the seller’s projections. Depending on the scope of the report and the buyer’s concerns, the Q of E team can look into a wide range of topics. For example, if the seller’s customers are mostly well-financed blue-chip companies, revenues are based on long-term contracts or repeating programs, and revenues have increased steadily, those earnings would be generally high-quality. However, if customers are mostly smaller companies, orders are lumpy or spotty, there are a lot of one-time orders, suppliers are small and overseas, the equipment was purchased in the ‘80s, and revenues have been up and down, the Q of E report would probably rank those earnings as lower quality.
The Q of E report also looks at the quality of assets, various accounting policies, the quality of the supply chain, financial controls, the level of the management team/financial reporting, IT systems, and a wide variety of other factors. The scope of the report depends on the concerns of the buyer and the complexity of the business. The costs also depend on those factors and can range from around $5K for a limited report to up to $100K for a complex report done by a large firm.
In recent years, sellers have become more proactive and have requested Q of E reports on themselves. This is a bit like getting a home inspection completed before selling a house or getting the mechanic to check out your car before you sell it online. Getting a sell-side Q of E report gives buyers confidence early on, uncovers issues, makes the process quicker, and is a strong signal that the seller is serious (and wants a high value for the company). Sell-side Q of E reports are becoming standard, so not having it puts the company at a disadvantage compared to other sellers.
If something negative comes up, you can hit the “pause” button and fix it before going to market, or at least disclose it in advance and avoid any surprises. Sellers who are thinking of going to market in a few years could get a report done now and have plenty of time to correct any issues. A refresh of the report when the company is ready to pull the trigger makes it easier to do and will be less expensive than the original report.
The owner or executive of a company has worked there for years, so you understand the business well and have accepted the risks of the business and industry. Owners can get blinded by familiarity, and they all think their businesses are perfect. Buyers may come from different parts of the industry and may view opportunities differently. Private equity, or other investors, may not know the industry well. A Q of E report can give the owners and executives a perspective of the business that they otherwise would not receive.
Who pays for the Q of E report? If it is a sell-side Q of E report, the seller pays. The investment pays off in higher valuations and a smoother deal. If the buyer asks for it, the buyer typically pays. However, some buyers may say the seller should at least pay half. If the buyer requests the Q of E, it is almost always after a letter of intent is signed, and the parties have entered into an exclusive due diligence period.
The main differences between a financial audit or review and a Q of E report are that audits check to see if the financials conform to GAAP, and they are backward-looking. Quality of Earnings reports take into account add-backs and a variety of risks, and also cover forward-looking projections. Q of E reports analyzes the business more from an operating perspective, whereas audits focus on accounting entries.
A great Q of E report can help support a higher valuation, better terms (more cash at closing, less earnout), a smoother negotiation and due diligence process, and better reps and warranties terms (or lower reps and warranties insurance premiums). It can help the buyer with their financing efforts and help them get approval from their board of directors or investment committee. A Q of E report does not replace buyers’ due diligence, but it can be a very important independent tool for understanding the business.