When considering selling a business or going through a sale process, it is important to understand that financials will be one of the first areas investors will look to when evaluating the business. Investors want to understand the financial profile of the business – its profitability metrics, cash flow, debt capacity, and ultimately the valuation they are willing to pay. As a seller, it is important to have a deep understanding of your financials to position your business appropriately and ensure you aren’t leaving any value on the table. This can be accomplished through a sell-side quality of earnings analysis (also referred to as a “QoE” or “Q of E”).
What is a Quality of Earnings Analysis?
A quality of earnings analysis is an objective financial analysis performed by a third-party accounting firm. The analysis digs deep into the business to help establish a realistic and accurate financial picture on a normalized basis. Unlike an audit, which verifies the company’s financials are in accordance with accounting principles, a quality of earnings analysis can restate the company’s financials by identifying and adjusting the impact of certain items that may not be reported correctly or don’t represent the true financial picture on a go-forward basis. This is accomplished by adjusting for items such as one-time events (e.g. unexpected shutdowns), non-business related personal expenses (e.g. vehicles, country club memberships, salaries to family members) or GAAP related accounting adjustments. A quality of earnings analysis can also analyze the company’s customers, product lines, other relevant business metrics, as well as test its cash receipts and expenditures compared to the reported numbers. This analysis helps understand the sustainable and normalized financial performance of the business at a very detailed level.
Do I Really Need to Have a Quality of Earnings Analysis?
The short answer is no. Having a seller’s quality of earnings analysis performed is not a requirement when selling a business. Hundreds of deals are closed each year with sellers opting to not have this analysis performed. However, the cost is typically recovered through the value gained by being proactive and having this complete before investors dig in. This also allows you the opportunity to identify and rectify any potential issues that may arise upon an investor’s diligence while also providing confidence in the eyes of investors. Nearly all investors will engage third parties to conduct this analysis, but the results are rarely shared with sellers unless the impact is negative, which typically results in a purchase price reduction. Any positive adjustments, or financial upside, found by the investors are lost opportunities for the seller to capture value. Another critical benefit of a Q of E is the benefit of accelerating the sale process. If you are worried about confidentiality, having a clean, well-prepared set of financials will help minimize the time in market and therefore, reduce the risk of confidentiality leaks. As you will hear investment bankers say, time kills deals, and so having a Q of E benefits the overall process.
How Much Does it Cost?
The cost of a quality of earnings analysis can vary widely based on the size of the business, the scope of the analysis, and the accounting firm. Sellers in the lower middle market can typically expect to spend roughly $40,000 to $200,000 on this analysis. While this can be a sticker shock for many, sophisticated sellers will find that having the financials packaged correctly can increase the valuation and likelihood of a deal closing in a timely manner with no surprises. This should be viewed as an investment into the ultimate transaction outcome, and ultimately worth the cost to the seller. As an example, if your business is worth $30 to $35 million, spending a modest amount to drive the value to the top end of the range is an investment with a great ROI.