Understanding Quality of Earnings when Selling A Business

September 16, 2021 | Article

The time has come to sell your business. Do you know what the process looks like to put it up for sale? What are the necessary preparation steps to take and who should be involved? After all, you’ve invested your money and countless hours in this business and you want to ensure you sell the business for what it is worth.

Whether you know it or not, you have been preparing for a sale for years. Now is the time to start developing the materials to explain your results and tell your story. Understanding your value prior to going to market gives the seller bargaining power. It can also help keep the deal on track and on time by identifying pitfalls well in advance. One of the best places to start with the sale of your business is by hiring a third party vendor to provide you with a quality of earnings report.

Quality of earnings due diligence is the first step. Here’s what else you’ll need to know to prepare for sale.

What is quality of earnings?
Due diligence is an opportunity for the seller to gain the buyer’s confidence and highlight the capabilities of staff and operations. If you are properly prepared for a sale, the due diligence process should not result in any surprises. If you are aware of any issues, it is best to bring them to the attention of your transaction team to put the best light on the issue, since it will likely be discovered during due diligence.

The process begins with taking a step back and putting yourself in the buyer’s shoes to look at the company’s three- to five- year history. A preparatory due diligence, sometimes called Sell-Side Quality of Earnings (QofE), covers the financial aspect of this process.

Quality of earnings (QofE) due diligence is the analysis of your organization’s financial information by an independent party. It’s a necessary step in the sale of your business because it helps assess and preserve the value of your business and gets you prepared for challenges and issues that may arise throughout the sale process.

An unbiased evaluation of the company’s operations through a financial lens using questions such as these is essential to understanding the value of the organization. Depending on how these questions are answered, waiting to sell for another year could return significant value. This additional time allows management to focus on improving key performance indicators and value drivers.

What are the benefits of quality of earnings in the sale of my business?
There are several key benefits of a sell-side QofE:

  • You get insight into how buyers are going to analyze earnings and key balance sheet areas. The QofE process also shows the potential buyer of your company that you have serious intent to sell and have invested the time necessary to ensure your company is sale-ready.
  • It allows you to take the time to clean up past financial issues and potentially increase value.
  • It ensures all add backs/adjustments are accounted for.
  • It prepares you for the hard questions you may encounter in the sale of your business. By walking through the sell-side QofE ahead of time, you’ll be prepared to tackle questions and areas of concern head on before you enter buyer conversations.
  • It allows you to prepare document requests ahead of time, alleviating pressure on your staff once the sale process begins.

What is the process for quality of earnings in the sale of a business?
The process for quality of earnings begins when you, the seller, are considering selling your company or a segment of your company. Typically, the timeframe is within six to 12 months after you decide to sell.

From there, the next step is to decide who should assist you in this process. This decision should happen internally with your key stakeholders, but also externally with trusted business advisors. Remember, quality of earnings is conducted by a party that is independent from your business, so you’ll need to research third-party accounting firms.

Once you decide to engage with a third-party service provider, you can begin to solicit offers from them. Ensure you are looking at more than just the cost of the provider. Ask questions about their experience, the quality of their product, the intended timeline for their process and more.

When you select a third-party service provider for your quality of earnings due diligence, you’ll need to identify a key person within your organization to communicate with them. This employee will be the person to answer data requests and ensure confidentiality throughout the QofE process.

As the QofE process proceeds, it’s important to stay involved. This allows you to better understand not only the due diligence process but also deal options, value points and the final deliverable.

There are a lot of steps when it comes to due diligence. We’ve developed a step-by-step guide to help you through it.

What information is included in a quality of earnings report?
The quality of earnings report highlights the key aspects of your business, including:

  • Normalized level of EBITDA and the addbacks to bridge from reported EBITDA to adjusted EBITDA
  • Fluctuations in annual and monthly financial information
  • Revenue and gross margin by product, customer or distribution segments
  • Operating expenses and employee analysis
  • Key balance sheet highlights
  • Normalized levels of working capital needed to operate the business

It includes questions like:

  • Have we had any significant one-time events, infused significant growth, or added process improvement capital that affected our financial performance?
  • Have we prudently managed our working capital and cash flow?
  • Do we have discretionary expenses affecting EBITDA?
  • How do our compensation packages or commonly owned property rents compare to the market?
  • Have we reasonably forecasted our growth?
  • What are the capabilities of the management team which will be in place post close?
  • Have we outgrown our current technologies?
  • How did your organization survive the COVID-19 pandemic?
  • What new business models did you embark on following COVID-19?
  • What is the outlook for your organization?

All of these areas are intended to show the buyer that everything is of normal course and that there are no “skeletons” hidden in the numbers. Buyers will typically disclose adjustments that are favorable to them, but by going through the QofE process, you will be able to ensure that adjustments that are favorable to you are taken into consideration.

Exit strategy has many moving parts. Check out our guide to help you set strategy and direction early.

How is a quality of earnings report different than an audit?
An audit is not the same thing as a quality of earnings due diligence report. Audits are not sufficient for due diligence in the sale of a business, because:

  • Audited financials represent outdated financial information (fiscal period ends). A QofE report will look at your current financial information as well as past financial performance.
  • Audits do not account for changes in operations, customers, products, vendors, accounting methods or significant accounting estimates.
  • Audits utilize historical GAAP compliant financials, which are not an ongoing indication of your financial situation.
  • Audits will not always call attention to one-time events that may impact your financial results.

How do I use quality of earnings to move forward?
If you’re planning on selling a business, QofE due diligence is an incredibly prudent and necessary step, but it’s not a process that you should do alone. It’s beneficial to work alongside a team of specialized advisors to help ensure your QofE report gives you the information you need to understand your business’s earnings and ultimately sell it at a fair and reasonable price.

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