In the context of mergers and acquisitions, being prepared is not just an advantage — it’s essential. Sellers who begin negotiations armed with clarity, confidence, and a thorough understanding of their financial standing are more likely to reach the closing table and have a favorable outcome. However, the road to a successful sale is often challenging, and many sellers find themselves unprepared to navigate the complexities of the process.
Much like staging a home for sale, preparing a business for sale requires planning and meticulous attention to detail. Yet, despite its importance, many sellers overlook a fundamental aspect of the preparation process: the sell-side quality of earnings (QoE). This tool serves as protection for sellers from potential pitfalls and empowers them to take control of the negotiation process.
What are Quality of Earnings?
A QoE analysis tells the story behind the numbers within the financial statements, providing confidence in a business’s underlying financial health and sustainability. The “earnings” in a QoE is typically measured in terms of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), distinguishing between recurring, normal revenue and earnings and one-off, nonrecurring, out-of-period, and erroneous items. Quality earnings are sustainable earnings. While buyers are interested in a business’s historical performance, their primary focus is on its future trajectory.
What is a QoE not? It is important to note that a financial statement audit or review is not the same as a QoE. They both serve a purpose, but you need to choose the right tool for the job. While sellers might think that their audited or reviewed financial statements are adequate for an M&A process, a QoE analysis goes further, often aligning financials with GAAP principles (though not always) and adjusting for certain factors typically outside the scope of a traditional audit. Below, we outline some key distinctions between an audit and a QoE:
| Focus | Verification of historical financial data for client | Analysis of financial health of seller |
| Considerations | Focuses on generally accepted accounting principles (GAAP) compliance | Considers GAAP as well as non-financial aspects |
| Timeframe | Typically only focused on fiscal years | Typically at least last 2 fiscal years and most recent trailing twelve-month period |
| Approach | Uniform and standardized approach and backward-looking | Tailored to client’s needs and objectives and tends to consider forward-looking elements (i.e., pro forma adjustments) |
| Flexibility | Generally more rigid in scope and approach | Allows for flexibility in scope and approach |
The Role of a Sell-Side Quality of Earnings
The sell-side quality of earnings is more than just an analytical tool; it serves as a strategic asset that can uncover potential deal-killing issues, prevent re-trading post-LOI, and enhance the negotiation process. By identifying and addressing potential add-backs and adjustments that the buy-side may not reveal, a QoE fosters competitive tension, often shortening the buy-side due diligence period and compelling buyers to submit competitive bids.
The QoE enhances the seller’s credibility by providing an objective analysis of the financials, reducing surprises, and accelerating the deal timeline. It strengthens the seller’s negotiating position by ensuring leverage is maintained once preliminary terms are set, preventing buyers from renegotiating based on undisclosed information.
The QoE provides insights into non-financial metrics and operational elements. By analyzing KPIs tailored to the company’s industry and other qualitative factors, a QoE can identify key levers within the business that can be optimized, as well as quantifies potential transaction synergies. These analyses can make the company a more attractive investment to both private equity and strategic buyers. This analysis not only highlights the sustainability of earnings but also provides a clear picture of the company’s potential.
Sell-side QoE simplifies the buy-side due diligence process. By delivering a thorough and transparent analysis of the financials, it instills confidence among potential buyers, making their due diligence more perfunctory and facilitating a more efficient deal process.
Beyond EBITDA: NWC and Net Debt
A typical full-scope QoE goes beyond just the profit and loss statement; it also includes an analysis of the balance sheet. Recognizing the interconnectedness of these two financial statements is crucial, as solely focusing on earnings can leave sellers shortchanged. Whether structured as an asset or stock deal, it is important to remember that some, or all, of the balance sheet ultimately is being sold.
This is important since most transactions are structured on a cash, debt, and tax-free basis with an assumption of a normal level of working capital. While these aspects may sound straightforward, they take on a more nuanced significance within the context of a deal. Certain items can be categorized as “debt-like,” and the definition of working capital extends beyond the textbook formula of current assets minus current liabilities.
Debt and debt-like items directly reduce the purchase price on a dollar-for-dollar basis, affecting the final cash received by the seller. Typical examples of debt-like items include accrued commissions, bonuses, paid time off, retirement benefits, transaction expenses, customer deposits, aged payables, and warranties, among others.
Additionally, the concept of establishing a working capital target and conducting a subsequent true-up ensures that the business maintains sufficient working capital to support its operations post-close. Just as a buyer would not want to purchase a car with an empty tank, they want to inherit the business with a normal level of working capital akin to buying a car with fluids topped off and enough gas to reach the next station. Buyers do not want to find themselves in a situation where they need to immediately inject additional cash to keep the business operating as usual. Therefore, a NWC target is typically established and documented in the purchase agreement. If the seller delivers less than this target at close, the seller owes cash to the buyer, and vice versa.
Net working capital and net debt are additional balance sheet items that can significantly impact cash to a seller in a transaction. Sellers generally aim for a lower NWC target while buyers aim for a higher target. Early identification and addressing of these elements can mitigate potential disputes and contribute to a smoother transaction overall.
For a more in-depth analysis of Net Working Capital and Debt-Like Items, we invite you to explore our additional whitepapers: Net Working Capital Peg in a Round Hole and Till Debt Do Us Part.
Planning for the Process
As you start to think about this process, it is important to remember that no two QoE’s are created equal. Each one can vary significantly based on a range of factors, including the specific needs of the client and the unique dynamics of the transaction. When getting quotes from different providers, it is important to understand the scope of work proposed by each to ensure you are making equivalent comparisons.
The preparation of a QoE goes beyond simply submitting financial statements and waiting for a report. It is a collaborative process that requires substantial engagement from the company’s management team. During the process, companies are asked to provide comprehensive financial data and engage in detailed discussions that can last several hours. These sessions enable the QoE provider to thoroughly understand the operational aspects of the business and gain a holistic understanding of how the operations and financials interconnect.
Timing is critical in any deal, and this holds especially true for a QoE. Completing the QoE early in the process, ideally in time to integrate key elements into the offering memorandum and go-to-market strategy, can proactively address potential issues. Typically taking three to five weeks to complete, the planning and coordination of a QoE are essential components to consider in the overall deal timeline.
In conclusion, a sell-side quality of earnings report is not merely an optional add-on but a strategic imperative in today’s complex M&A landscape. By investing in a QoE analysis, sellers can enhance credibility, command higher valuations, and navigate the transaction process with confidence and clarity.
