Are you thinking about merging with or acquiring a business? CPA-prepared financial statements can provide valuable insight into historical financial results. But an independent quality of earnings (QOE) report can be another valuable tool in the due diligence process. It looks beyond the quantitative information provided by the seller’s financial statements.

These reports can help buyers who want more detailed information — and help justify a discounted offer price for acquisition targets that face excessive threats and risks. Conversely, when these reports are included in the offer package, it can add credibility to the seller’s historical and prospective financial statements. They may also help justify a premium asking price for businesses that are positioned to leverage emerging opportunities and key strengths.

Deep Dive

QOE analyses can be performed on financial statements that have been prepared in-house, as well as those that have been compiled, reviewed or audited by a CPA firm. Rather than focus on historical results and compliance with U.S. Generally Accepted Accounting Principles (GAAP), QOE reports focus on how much cash flow the company is likely to generate for investors in the future.

Examples of issues that a QOE report might uncover:

A QOE report typically analyzes the individual components of earnings (that is, revenue and expenses) on a month-to-month basis. This helps determine whether earnings are sustainable. It also can identify potential risks and opportunities, both internal and external, that could affect the company’s ability to operate as a going concern.

EBITDA vs. QOE

It’s common in M&A due diligence for buyers to focus on earnings before interest, taxes, depreciation and amortization (EBITDA) for the trailing 12 months. Though EBITDA is often a good starting point for assessing earnings quality, it may need to be adjusted for such items as nonrecurring items, above- or below-market owners’ compensation, discretionary expenses, and differences in accounting methods used by the company compared to industry peers.

In addition, QOE reports usually entail detailed ratio and trend analysis to identify unusual activity. Additional procedures can help determine whether changes are positive or negative.

For example, an increase in accounts receivable could result from revenue growth (a positive indicator) or a buildup of uncollectible accounts (a negative indicator). If it’s the former, the gross margin on incremental revenue should be analyzed to determine if the new business is profitable — or if the revenue growth results from aggressive price cuts or a temporary change in market conditions. If the latter, additional focus may be required to evaluate customer payment trends and viability

Flexible Tool 

Fortunately, the scope and format of QOE reports can be customized, because they’re not bound by prescriptive guidance. The best such reports, whether prepared for a buyer or seller, focus on core issues of interest and avoid including generic and /or filler information. Contact us for more information about how you can use an independent QOE report in the M&A process.

© 2021

Low interest rates and other factors have caused global merger and acquisition (M&A) activity to reach new highs in 2021, according to Refinitiv, a provider of financial data. It reports that 2021 is set to be the biggest in M&A history, with the United States accounting for $2.14 trillion worth of transactions already this year. If you’re considering buying or selling a business — or you’re in the process of an M&A transaction — it’s important that both parties report it to the IRS and state agencies in the same way. Otherwise, you may increase your chances of being audited.

I was recently speaking to a group of business owners, and when asked how many had received unsolicited offers to invest or buy their business outright, half the hands in the room shot up. I was a little surprised, but with the amount of undeployed cash held by private equity firms, it makes sense why so many are on the lookout for good companies.

How do you position your company so it is sought after by private equity firms or investment bankers, and when opportunity strikes, how do you make sure you are prepared for a sale?

With trillions of dollars expected to change hands as baby boomers retire, more and more business owners will face potential buyers with little or no experience in being part of a transaction. Conversely, investment bankers, private equity groups, M&A attorneys and Certified Public Accountants, who are insiders of the Merger & Acquisition world, see transactions every day as part of their role.

Preparing for a future exit requires being ready when the opportunity strikes. Not only does this include being prepared for discussions with potential investors, but it also means preparing yourself individually.  How does one prepare for such a monumental change in lifestyle and one with so many outside factors? First, prepare yourself personally.  Second, ensure that the story of your business is well-presented.

It’s difficult to plan for an event when you don’t know the specific date or conditions, but that is exactly what business owners must do to effectively prepare for the sale of their business. What do you want your life to be like after the sale? The economic outlook may be pointing to a recession sometime in the next 12 to 24 months, depending on which economist you listen to. If you believe that you will get a higher price for your business before a recession, do you want to try to time the market? Or will your timing be based on a personal choice? Another option often heard is taking additional time to grow your business to increase the value.

To tell your story well the numbers will need to back up the narrative. M&A professionals will expect to see three years of financial statements, utilizing Generally Accepted Accounting Principles. Before opening up your financial statements, take a close look to identify any current or future cash flow issues from the buyer’s perspective, and be prepared to answer questions about significant business issues.  Through a sell-side quality of earnings, you can adequately anticipate and address any future buyer’s questions prior to meeting with an investment banker.

Read more: 6 strategies to increase the sale value of your business.

The decision to exit your company is the first step in a long process. Business owners considering a sale should develop a bench of qualified M&A professionals to provide business advisory services focused on reaching your objectives. The deal team should include a wealth advisor, M&A attorney, CPA, and investment banker. By developing these relationships early, your M&A professionals will understand your needs and objectives clearly and a well-established work style will be in place prior to the sale of your business. Much of the frustration and delay that arises during the diligence and documentation process can be avoided through careful planning and preparation.

More and more sellers are conducting a sell-side quality of earnings report. It is a dry run through the buyer’s due diligence process and helps uncover changes in your business. Your historical financial statements allow for a basis to project future earning potential of the business. A clear story of your company’s future earning potential, backed up by audited financial statements and Sell-Side Quality of earnings reports, will put you in a better position to withstand the rigors of due diligence. During due diligence the potential buyer will verify that they want to buy the business. Once they have determined that, they will be looking for items or issues that may justify lowering the offer price. Being prepared for this scrutiny is critical to maximizing the selling price of your business.

Are you considering the sale of your company or getting calls from interested private equity firms? Contact our accounting and business advisory experts today for a consultation.

No matter how successful your organization is and how proud you are of the business you’ve built, there will come a day when you’ll need to step aside. Whether you sell the business to a private buyer or decide to go public, relinquishing control of a company you founded and have nurtured since day one can be painful.

However, even if the final decision is still off on the distant horizon, taking into consideration the inevitable passing of the torch will help you sell your business at a higher value and make the transition smoother for everyone involved. By shoring up your exit strategy well ahead of time—or at least, starting to turn it over in your mind and initiating a discussion with your business advisor—you’ll be in the best position to proactively and positively impact the outcome.

Start working with these six strategies—the “Six Ps,” as I call them—sooner rather than later. Consistently implementing the “Six Ps” throughout the development and growth of your business will help you maximize the enterprise value of your organization when the time is right to move on.

Get clear about exactly what you offer and exactly how you stand out from your competition. Become comfortable articulating it in words, in writing, in front of large groups and during intimate gatherings.  Identifying your sustainable competitive advantage—and communicating it quickly—will increase the value and attractiveness of your business to potential buyers or investors.

This might sound like a no-brainer, but take a hard look at your numbers. Potential buyers certainly will.

If yours is a great product that is filling a true market need, you should be achieving a reasonable profit margin. Start-up entities might require a few years to break even or reach profitability, but this is to be expected. However, if yours is a mature company, you should be posting a trend of profits that you can demonstrate to buyers. The historical and future trend of growth is key to many deals where the purchase and sale value of the enterprise is based on a common metric being a multiple applied to earnings.

Potential buyers are going to look for ways that your product or service complements their investment portfolio. If you possess efficient processes that they can apply to other businesses they own, your company will suddenly appear even more enticing (read: more valuable). Take the time to refine and develop every aspect of the processes you use to bring your product or service to market. Get your distribution channels, franchising models and any other integral processes squared away, as they all have concrete ancillary value to buyers. Solicit unbiased input from your business advisors, if needed. Their perspective can be extremely valuable.

When was the last time you took a close look at the basic nuts and bolts of how your company is run? Buyers will scrutinize every aspect of every business practice, reviewing the entire scope of your organization, from operations to overall governance (ex. board of directors), to the effectiveness of your internal controls. Remember: well-run businesses command a higher value. If your infrastructure and systems need updating, the time to act is now.

You’ve probably heard the old business adage, “Great deals depend on three things: management, management, and management.” Evaluate all the individuals in every department of your company: is everyone in the ideal position? Future buyers will prioritize well-trained, solid performers—and their offer price will reflect it. If you’re a sole-proprietor owner, ask yourself truthfully if your business can continue to prosper without you. If the answer is “yes,” then you have done a great job of putting the right people in place. If not, you should act now to identify and fill the gap in skills and positions.

This one is probably the most important of all since it underscores the other strategies. The bottom line is: be prepared. Whether you’re thinking of selling within the next year or within the next decade, it’s never too early to focus on the future. Your business advisor can help you draft a plan that will break down each of these components into manageable steps so the whole process is less overwhelming.

Products, profits, processes, practices, people, and planning…these six fundamental components of your organization will determine the strength of the sale. By paying attention to the things that buyers will be looking for, you can make sure that you position yourself for a profitable sale and an enduring business that continues to succeed, long after the reins change hands.

Generational family transfers, private equity investors, a sale to a new owner or strategic investor, going public… Whether the result of your long-term strategic plan or being faced with a sudden opportunity to sell, a successful business is likely to undergo due diligence at some point. The onslaught of due diligence from a potential buyer can overwhelm your business if you’re not ready for the level of scrutiny your organization will receive.

Here are some key suggestions from our business advisors to prepare for due diligence to help the process proceed smoothly.

Ensure that you have the right people overseeing all essential internal and advisory roles. Due diligence digs deeply into numbers and performance, so you’ll need to make sure that department heads, executives, and external teams are prepared to deliver pertinent information without disrupting business operations. Sole owners should have strong management in place that will allow for a seamless exit upon sale.

Record retention issues can cause major snags during due diligence. Maintain a complete set of well-organized data, supported by a reliable backup system. Whether you receive a request for internal records or information from any of your business advisory service partners, your data should be readily available and easy to navigate.

Buyers or sellers will want to see evidence that you are current on all compliance issues, including income tax filing, payroll taxes, sales taxes, insurance, and other regulatory reports, such as FDA or EPA filings. They will also want evidence that your employee benefit plans (things like 401(k)s and profit-sharing plans) are being managed consistently and within all state and federal guidelines.

Just because you’re undergoing a due diligence investigation doesn’t mean that you can put your organization on hold. Business must continue to operate as usual. Ensuring that you have the right resources and information available at your fingertips frees up your staff to continue to focus on their daily responsibilities.

When you are faced with a significant business event that requires due diligence, align your external business advisors to make sure everyone is working together. Your attorney, CPA, investment banker, wealth manager, and any other teams that provide critical business advisory services are all dedicated to helping you achieve your best outcome. Loop them in early so they, too, can prepare materials on their end and contribute to your success.

Get organized well before there is any need to conduct due diligence on your organization. Thinking about your exit plan, even if it is on the distant horizon, will prepare you for this rigorous process once it’s upon you. Maintain reliable operating processes, data systems, technology and accounting systems. Be as efficient and effective as possible with the entire range of procedures that apply to your business, internally and with your customers and vendors externally. Ideally, yours should be a solid, well-run organization at every point in your company’s lifecycle.

As with any important business transaction, it’s always better to get organized well in advance, so you’re not left scrambling. Don’t wait until you’re facing (or faced with) a transaction to get your operations, records and business processes in order. Documentation is one thing, but having a company that already runs efficiently and sustainably is better.