5 Reasons Sellers Need a Quality of Earnings Report

M&A deal flow was sidelined for much of 2022 and 2023, but the economy’s soft landing, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.

As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner.  For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace.  And it can be critical to the ensuing due diligence processes buyers apply to targets.

The scope of a QofE engagement can be tailored to the needs of the seller.  Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business.  The process can encompass both the financial and operational attributes of the business.

In this post, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses to market.

1. Maximize value by revealing adjusted and future sustainable profitability.

Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their businesses.  Every dollar affirmed brings value to sellers at the market multiple.  Few investments yield as handsomely and as quickly as a thorough QofE report.  A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction.  The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers.  The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers.  Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.

2. Promote command and control of transaction negotiations and deal terms.

Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process.  A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers.  After core pricing is determined, other features of the transaction, such as working capital, frameworks for roll-over ownership, thresholds for contingent consideration, and other important deal parameters, are established.  These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements.  The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.

3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.

The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences.  Family businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters.  The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses.  Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk.  In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.

4. Financial statements and tax returns are insufficient for sophisticated buyers.

Time and timing matter.  A QofE report improves the efficiency of the transaction process for buyers and sellers.  It provides a transparent platform for defining and addressing significant reporting and compliance issues.  There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement.  This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.

For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative.  While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal.  Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process.  A QofE engagement can be a powerful supporting tool.

5. In one form or another, buyers are going to conduct a QofE process – what about sellers?

Buyers are remarkably efficient at finding cracks in the financial facades of targets.  Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms.  It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors.  In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground.  If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.

The stakes are high in the transaction arena.  Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone.  A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome.  If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.