Your client e-mailed you this morning to tell you they are considering selling their business. They want to know more about the due diligence process and ask you what it will entail. You know that due diligence is an area that has evolved immensely over the past few decades, increasingly becoming more sophisticated. You’ve even heard the term “quality of earnings” thrown around but are not entirely sure what it actually is or why your client should concern itself with it. Before you set up a meeting with your client, take a read of this article. I recently spoke with David Prowse, a Toronto-area CPA who specializes in business exit planning, valuations, and financial advisory work, what a Quality of Earnings report includes, why it’s increasingly critical to prepare one for the sale of the business (even before a Letter of Intent has been signed), and current trends that are developing in this landscape.
Prowse noted that the primary objective of a Q of E report is to identify the true cash flow of a business, commonly measured with Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”). Cash flow is important because most deals base the valuation multiple on this metric. This process is referred to as the “normalization” of cash flow. While M&A advisors commonly do this themselves as part of the buy-side or sell-side process, a Q of E report provides both buyers and sellers certain advantages over relying on the M&A advisor’s work alone.
Prowse continued that Q of E reports is usually prepared by an independent professional, often holding a Chartered Professional Accountant (|CPA”), Chartered Financial Analyst (“CFA”), or Chartered Business Valuator (“CBV”) designation. Because they are independent, they have no vested interests in the outcome of the sale. Through their independence, both buyers and financial lenders are more confident the cash flow used in the valuation is a reflection of the true economics of the business.
I asked Prowse what were some of the most common adjustments seen in reports. He told me that at a basic level, reports will adjust for management compensation ( to reflect market values of salaries for management positions), occupancy costs (when sellers own their own real estate), related party transfers between members of a corporate group, non-recurring events, non-operating income, and expenses, along with the removal of any personal expenses run through the company by the owner such as vehicle expenses.
However, he added that more detailed reports will also examine:
· Run-rate adjustments (to reflect mid-year changes in the business such as lost customers or salary costs related to increased staff).
· Impact of accounting policy changes from year to year or mid-year.
· Inconsistent application of accounting policies.
· Reserves for accounts receivable and inventory (for example, not properly reflecting uncollectable accounts or obsolete inventory).
· Capital expenditures & working capital (since management of these areas can create large injections of cash by a prospective buyer).
Prowse noted that trends in key revenue and expense accounts along with working capital are critical for prospective investors to understand and should be examined as part of the analysis. Declining or inconsistent results from year to year may be a red flag to a prospective buyer to investigate further as part of their due diligence. In addition, key metrics such as gross margins, operating margins, inventory turnover, and return on equity can provide insights into the financial health of the company.
When I asked whether a Q of E report was critical to the M&A process today, Prowse replied “Absolutely. Q of E reports is increasingly becoming ‘must haves’ to get the deal done. Banks are increasingly asking for one and buyers are using them to complement their due diligence process.” Prowse added that the Q of E report can be tailored to the size of the company and the specific concerns of the buyer. Reports for $100 million deals will likely differ from those for $10 million, but the fundamental objectives of the report are the same. The report’s primary objective is to raise red flags that either need further investigation or may indicate the deal should be called off. Buyers can also tailor their due diligence programs based on risk factors raised in the Q of E reports.
Traditionally, it has been buyers who have paid for Q of E reports to be prepared, but increasingly, sellers are paying for reports to be prepared before a Letter of Intent has even been signed. A sell-side Q of E report can be used to help the seller identify potential red flags before going to market. This gives management time to address some key issues ahead of time. Sell-side Q of E reports also plays an important role in providing transparency to prospective buyers. “Having one prepared ahead of time helps bring buyers to the table,” explained Prowse, “and it puts the seller in a positive light since they are approaching the transaction in a spirit of transparency.” Prowse also noted that financial institutions are now requiring Q of E reports to be prepared for both smaller deals to achieve the necessary financing. “It is fast becoming the de facto standard for all M&A deals requiring lending. Not having one might be a potential deal killer.”
You contemplate all this and, renewed with vigor with new information, you arrange a call with your client to discuss this important topic. You confidently explain to the client to expect a Q of E report to be prepared by the buyer’s advisory team and go over the common adjustments that might occur. You emphasize that banks increasingly want this work done and even suggest that a sell-side Q of E report prepared ahead of time may prove advantageous by bringing additional interested parties to the table due to transparency and maybe even improving the valuation multiple. Your client listens intently and eventually agrees with your assessment and thanks you for prudent counsel, offering they think a sell-side Q of E report might be the way to go. You conclude that due diligence may still not be fun, but they’ll be giving themselves the best chance for success.
Mark Borkowski is president of Mercantile Mergers & Acquisitions Corporation. Mercantile specializes in the sale of mid-market companies sold to strategic or private equity buyers. He can be contacted at firstname.lastname@example.org or www.mercantilemergersacquisitions.com. David Prowse is the Founder of Velorum Business Advisory, a firm that specializes in financial advisory services, business exit planning, and valuation. He can be reached at email@example.com.
Disclaimer: The views expressed herein are those of the authors; they do not necessarily reflect the views of Private Capital Journal and CPE Media & Data Company.