Quality of Earnings Reports in M and A Transactions

Quality of Earnings (“QOE”) reports have become de rigueur in recent years in M&A transactions. QOEs provide an independent and objective assessment of a company's earnings to help buyers determine if it's a good investment.  They assess the accuracy and sustainability of a company's earnings, uncovering potential risks and issues that could affect the business value. QOEs help verify stated and adjusted EBITDA, examine projected financial performance, and assess how sustainable revenue and earnings are.

History and Purpose.  In the first several years, starting a decade or two ago, both financial and strategic buyers started requiring them to be performed after letters of intent were signed, and they were done during the due diligence phase.  What happened, though, is that the QOEs often gave sellers a basis for seeking to re-trade the transaction, given they often highlighted facts that supported a lower valuation.  For instance, they might have identified an upward adjustment to EBITDA that was inappropriate and in fact should not have increased EBITDA. 

Today, it is a best practice for sellers to procure a QOE prior to going to market.  With a QOE in hand, sellers are much better prepared for the process, confident that a sophisticated third party has scrutinized the business and the represented adjusted EBITDA.  It will not necessarily obviate the buyer’s need for their own QOE, but it can, particularly if it was prepared by a large, brand-name provider.

Providers.  Generally, accounting firms or other financial consultants prepare QOE reports. They are usually done by an independent third party with no stake in the transaction.  We recommend using a national, or super-regional, name brand firm, simply because they carry more credibility.

Components.  The key components of a QOE report are analysis of adjusted EBITDA; examination of net working capital, debt, and assets; review of accounting policies and financial controls; and analysis of customer and vendor concentration, profit margins, and trends.  QOEs differ from audits in that they focus specifically on facilitating M&A transactions. They provide more granular monthly analysis versus annual audit data. And a QOE examines sustainability and quality of earnings, not just GAAP compliance.  

Benefits.  The benefits of a QOE are:

 

·       It provides a normalized view of core earnings by adjusting for non-recurring items;

·       It gives buyers critical information beyond standard financial statements;

·       It allows sellers to prepare and identify issues before going to market; and

·       It facilitates the transaction process by providing organized financial data.

Logistics.  QOEs typically take four to six weeks to complete. They cost generally between $50,000 and $150,000, depending on the complexity of the business. Whoever orders the QOE generally pays for it.  This may tempt a seller to wait and let the buyer order and pay for the report, but we recommend against this.  Better to spend $100,000 than go down the road with one prospective buyer who will almost certainly use a QOE to re-trade a deal after months of time and effort in the process.

When You Don’t Need a QOE.  There are circumstances where a seller can likely skip procuring a QOE:

·       The company is regularly audited and has clean audit opinions;

·       The company’s accounting and reporting practices are “squeaky clean”; and

·       Any adjustments in the Adjusted EBITDA are “beyond reproach”.

 Traversi & Company is a premier sell-side M&A advisory firm - a boutique investment bank - serving the lower middle market. Visit us here.