Sell-Side Quality of Earnings Report: How to Set the Stage for Valuation

Updated on: December 14, 2022

Authored by Matthew Roberson, Director | SC&H Capital

For founder-owned businesses interested in exploring a sale, getting a sell-side quality of earnings (QoE) report might seem like an unnecessary expense and yet another step in an already complicated process. However, QoE reports provide benefits that outweigh their cost and complexity and often increase the likelihood of a successful sale.

What is a Quality of Earnings?

A QoE report is a standard part of due diligence in M&A transactions. These reports thoroughly and objectively evaluate a company’s financial statements to present accurate historical earnings and assets, ultimately laying the foundation for the sustainability of future earnings. A QoE will also uncover any anomalies—particularly one-time revenues or expenses that obscure the normal operation of the business.

While the report’s contents can vary, there is usually a set of standard features that often include:

  • Revenue and profit analysis by categories and customers
  • Summary of EBITDA (earnings before interest, taxes, depreciation, and amortization)
  • Analysis and rationale for adjustments to EBITDA
  • Working capital analysis
  • Identification of key financial performance indicators
  • Presentation of recast financials
  • Assessment of key accounting policies and practices

A QoE report from a reputable provider will give M&A advisors a stronger financial foundation to paint the financial picture in the Confidential Information Memorandum (CIM). This financial foundation will ultimately support the basis for the valuation proposed when running a bid process. There have been instances where a seller gets an attractive offer, but in diligence, the buyer discovers an issue with reported earnings, thereby diminishing the attractive offer.

The heightened scrutiny of the QoE process gives sellers confidence in their reported numbers and, ultimately, a higher level of confidence in the sustainability of a buyer’s bid through the due diligence process.

What is the Value of Conducting a QoE Report?

By proactively obtaining a QoE, sellers can get ahead of the process and evaluate the financials of their business through the lens of a buyer. In turn, sellers gain a clearer picture of their relative strengths and weaknesses before they go to market. This allows the appropriate time to better position the business for a sale or fixes the issues identified in the report while ensuring the Chief Financial Officer (CFO) is prepared to answer questions that inevitably arise in due diligence. This in turn, expedites the financial diligence process and can accelerate the time to close.

For instance, in Shank’s Extracts sale to Universal Corporation, parsing below top-line revenue allowed our M&A team to position the company on strengths at the product line level that, without the help of a QoE provider, would not have been as obvious. That positioning, combined with a competitive process, led to a successful transaction.

Getting a sell-side QoE report also demonstrates to the buyer market that a seller is sophisticated enough to bring in advisors and is willing to invest in the M&A process, signaling bona fide transaction intent. Buyers love to see companies that have sell-side QoE reports because it elevates the attractiveness of the opportunity by lowering the transaction risk in a buyer’s eyes.

Demonstrate Integrity and Quality

While some founders might assert their company’s financial statements are sound and prefer to forgo the additional cost, the universal benefits of signaling and speed to close are well worth the initial investment. More than just providing these known benefits, QoE reports will invariably uncover something new that was previously unknown. These particulars, though hard to measure at the outset, typically provide more negotiating leverage and make the difference in a successful transaction.

Learn how to position your business for success with SC&H Capital.

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