Quality of Earnings—What Buyers and Sellers Need to Know

If you are party to an M&A transaction, regardless of your role, you can expect to hear the term quality of earnings (“QoE”). Determining QoE is one of the most common and vital exercises performed in any M&A transaction. When performed by a Buyer, it is referred to as a buy-side QoE. When performed by a Seller, it is referred to as a sell-side QoE. The work, analysis and content of buy-side and sell-side QoEs are very similar, with the difference being the party commissioning the work. A QoE exercise evaluates and determines the sustainability of a business’ earnings and cash flow generation capabilities.

The purpose of a QoE is to understand the sustainability of a company’s future earnings—specifically EBITDA, which is not a term recognized by GAAP or evaluated as part of an audit. The scope of a QoE is tailored to address items of specific interest or concern, with a focus on understanding a business’ story, operating trends, metrics and KPIs – all to ensure an appropriate EBITDA.

Many business owners assume that an audit is the same as or a replacement for a QoE; however, a QoE is very different than an audit. An audit is more rigid, follows a standard scope, and is performed only by certified public accountants and governed by specific accounting standards. An audit is very balance sheet oriented, focused on historical information and ensures that financial statements conform to generally accepted accounting principles (more commonly referred to as GAAP). While a QoE is often performed by a certified public accountant, it is not required. It can be performed by a financially competent person/organization with a strong accounting/financial and business acumen.

Buy-Side QoE

A buy-side QoE is a best practice for the most astute Buyers—a standard part of their pre-acquisition due diligence. It is generally the first exercise that follows the signing of a letter-of-intent. Buyers usually incur the cost to engage a third party to perform the QoE. A buy-side QoE requires significant input, information and support from the Seller and typically takes about a month for the Buyer’s third-party service provider to complete.

The party performing the QoE is tasked with confirming the EBITDA presented by the Seller and oftentimes includes identifying adjustments to arrive at a normalized and appropriate EBITDA. Adjustments can relate to one-time sources of income (e.g. PPP forgiveness), non-recurring expenses (e.g. owner personal costs), out-of-period charges (e.g. bonus payments recorded in one period related to performance in a previous accounting period) or even a change in accounting policy that impacts the financials but does not reflect a change in the cash flow generation of the business. It is important to note that adjustments identified during the QoE do not indicate that financials are erroneous—they can be proper from an accounting standpoint, but some forms of financial presentation muddy the waters when assessing the sustainability of earnings and EBITDA.

As part of the process of identifying adjustments to EBITDA, QoE also provides key business insights and highlights key performance trends. Through the QoE, a Buyer should gain a deep understanding of the business and its operations: key customer relationships and trends, key vendor relationship and trends, margins, significant and/or unusual accounting policies/practices, related party transactions, concentration considerations (e.g. customer, vendor), backlog and pipeline considerations and headcount/employee statistics.

Sell-Side QoE

Think of a sell-side QoE as akin to taking a stress test in advance of running a marathon to ensure that your body can handle it. A sell-side QoE is performed by a third party and designed to help the Seller understand the business from the perspective of a potential Buyer. Sell-side QoEs are commissioned by Sellers and done in advance of a Seller engaging with a Buyer. A Seller will make this investment for the purpose of uncovering and getting ahead of potential issues/concerns that a Buyer will likely raise during diligence. Similar to a buy-side QoE, a sell-side QoE requires significant input, information and support from the Seller and typically takes about a month to complete.

If issues or adjustments are identified as part of the sellside QoE, Sellers can take remedial actions to eliminate or mitigate issues so that they are non-issues by the time a potential Buyer performs its due diligence. The return on investment for a sell-side QoE is an accelerated due diligence process with better credibility throughout, which collectively should increase (or at least preserve) the initial agreed-upon valuation.

During the sale process, Sellers typically will provide a Buyer with the sell-side QoE, but Buyers will still engage a third party to perform a buy-side QoE. Having the sell-side QoE will help make the buy-side QoE exercise more efficient.

When entering into a strategic transaction, whether you’re a Buyer or Seller, it’s important to arm yourself with as many tools as possible to allow you to maximize value (if a Seller) and manage risk (if a Buyer.) The QoE is an effective tool that helps to accomplish both.