Founders and business owners looking to make an Extraordinary Exit™ are usually keen to have the M&A process move along at a good pace. One key enabler to achieve these results is by conducting a Quality of Earnings (“QoE”) in the early stages. A QoE is a custom report developed by an independent third-party that gives prospective buyers further insights and understanding of your company’s financial health and profitability. It is different to an audit and can help both the seller and the buyer. A QoE bridges the gap between historical financial reports (such as an audit) and due diligence needs, as well as boost EBITDA buy removing adjustments that are not reflective of the business when the buyer buys it.
Table of Contents
1. Understanding the Difference Between a QoE and an Audit
2. Benefits of a QoE for Buyers and Sellers
4. QoE Procedure in the M&A Process
Understanding the Difference Between a QoE and an Audit.
There are three key differences between an audit and a QoE. Firstly, a QoE report is completed by a third-party on your behalf, which allows it to be flexible and tailored. Audits are completed by an independent party to ensure GAAP compliance. Secondly, a QoE report focuses on your income statement, working capital, adjusted EBITDA and other business metrics, whereas audits generally evaluate the financial statements taken as a whole. Lastly, a QoE reviews your historical reports to determine the profitability under normalized operations, while audits are completed by looking at reported historical financials only.
Benefits of a QoE for Buyers and Sellers.
A QoE has significant benefits for both sides. For the seller, a QoE provides a more representative look at your business as it will be valued by a potential buyer before entering the market and can help identify adjustments that can be made to remove one-time costs or items that are not going to be relevant to a buyer, as well as find inconsistencies in your financials that you could consider addressing. With a QoE in hand, a buyer can get a better understanding of the value drivers within the business and a clearer picture of their profits and losses after they have been normalized.
What’s important to remember, and why the QoE is often recommended, is because it can shorten the due diligence time. With a QoE in hand, a potential buyer will have a clearer view of the financial picture of the company, reducing their data requests and the workload effort on the seller. The reduction in time can be dramatic, as much as reducing 100 hours of data work for the seller without a QoE to as little as 10 hours, plus the approximate 10 hours it will take for the QoE process, net a reduction of total seller engaged time of close to 80%.
STS Capital recommends completing a QoE analysis for several reasons beyond just reducing the due diligence period. Firstly, it enhances clarity by simplifying intricate financial structures, offering buyers a cohesive overview. Secondly, it aids in identifying opportunities for earnings improvement by highlighting adjustable costs like one-time business activities or irregular travel expenses, as well as discerning the benefits of in-house staff versus external consultants. Thirdly, it expedites the deal process by preemptively addressing potential buyer inquiries, thus accelerating negotiations. Additionally, it serves as a risk management tool, detecting and resolving financial reporting risks early on, minimizing surprises during bidding or due diligence. Lastly, it provides valuable insights, potentially offering strategies to streamline operations before the outreach phase commences.
Three Principles of a QoE.
Navigating the intricacies of QoE analysis involves adhering to three fundamental principles, each designed to cater to the unique characteristics of your business and provide prospective buyers with a comprehensive understanding of its financial health and potential.
- Tailored Engagement: Each company is different, so when it comes to QoE consulting, a tailored strategy is essential with flexibility in the approach, depth and scope of work to meet the unique needs of your business.
- Forward-Looking Normalization: Your QoE analysis is based on your economic earnings considering both the historical and normalized financial earnings on a go-forward basis. By normalizing your financial results, adjustments can be made to the historical financial statements and enhance your EBITDA by removing expenses that would not be reoccurring for the buyers. This helps the buyer determine a reasonable estimate of your company’s potential and sustainable financial earnings.
- Consideration of Financial and Non-Financial Aspects: The QoE framework looks beyond the financial statements and investigates underlying non-financial aspects to help prospective buyers understand the key operating and financial metrics of your company.
QoE Procedure in the M&A Process.
- Assess QoE Need Early: Determine the potential benefits of a QoE report at the outset of the M&A process and identify whether you need one.
- Selecting QoE Providers: Look at recommended QoE providers to help you establish the scope of work, cost estimates, and site considerations. Since a QoE must be conducted independently, choose a provider that best suits you and collaborate directly with them.
- Evaluate Provider Options: Consider factors like their industry experience, continuity of consultant teams, and their proficiency in defending QoE findings to buyers when selecting from multiple QoE providers.
- Pre-Engagement Tasks: Once you have selected a QoE consultant, determine the report’s scope, and specify the historical years and depth of analysis. It is best to disclose all your risks or concerns upfront so that the consultant can address and mitigate them through the process.
- Data Sharing and Discussion: Share your company data with the QoE consultant, including suggestions for expense and revenue adjustments or normalizations.
- QoE Report Compilation: Once the preliminary phase is complete, your consultant will compile the QoE report detailing their findings and adjustments.
- Post-Report Defense: After report completion, your M&A advisor can assist in defending any findings and make necessary adjustments to potential investors or acquirers.
- Report Updates: As the deal progresses towards closure, ensure your QoE report is updated to the latest month, potentially led by the buyer.
“It is worth viewing your QoE consultant as a core team member and not just an external party. They are an asset that can present your company better while also providing a level of protection when defending your financial performance to buyers. It can be worth assigning an internal staff member to be a key contact to facilitate and coordinate the QoE project as to help streamline and speed up the overall process.” Wade Atherton, STS Director.
Once the QoE process is complete, your selected M&A advisor should leverage the findings of your QoE report, such as a review of revenue recognition practices, cash to accrual conversion, and an accurate reflection of your company’s expenses under normal operations, to provide expert advice on the steps you need to take to get the maximum value and achieve an Extraordinary Exit.
Maximizing Deal Confidence.
“It goes without saying that a Quality of Earnings (QoE) report is a formidable asset, irrespective of your position at the negotiating table. When executed effectively, and at the right time in the exit process, it can transcend mere financial data, offering invaluable insights into the real core drivers of value.” Andrew Barrett, STS Managing Director.
STS Capital Partners is an international sell-side advisory firm of expert guides helping entrepreneurial and privately held businesses achieve Success to Significance™ through Selling to Strategics™, making Extraordinary Exits possible. Contact us to guide you through your QoE process and help you get the maximum value for your business.
