Quality of Earnings

Mid-market M&A transactions have evolved over the last 10 years to now include in most cases a Quality of Earnings due diligence report as part of the due diligence process.  QofE for short, are now becoming mandatory in most M&A and financing transactions.  This is particularly true when the buyer is a financial buyer or private equity and when there is a significant amount of bank financing being used in the transaction.

CCC’s sale process anticipates the need for QofE within the buyer’s due diligence process.  We work to make sure the process is geared towards accommodating a QofE and that the financial data and representations made in selling the company will be supported by the findings of the QofE report.

For business owners understanding more about the QofE will:

• Help them prepare for the sale process; and
• Reduce their level of frustration during the due diligence process.

Who is involved?

For the most part QofE reports are done by specialized groups within the public accounting firms.   These team members become part of the buyer’s professional deal teams alongside other accountants and tax specialists.   One of the key facets is that these groups have a level of “independence” which helps their reports be relied upon by the parties requesting a QofE be completed.

There are two main constituents who rely on the QofE reports.   The buyer, who uses the findings in their underlying analysis of risk and value.  The banks and other lenders or investors who use the findings of the report in their credit or investment risk assessment and underlying approval processes.

What is a QofE?

A QofE is different than an audit or review engagement report.  The purpose of the QofE report is to investigate and comment upon the risk and sustainability of a company’s reported profitability and cash flow.  It is a special purpose report issued to the party requesting it. The report provides analysis and observations ultimately providing comments on the estimate of “sustainable” EBITDA¹ and cash flow. This differs from an audit of the financial statements that is an opinion that is issued based on a scope of work to ensure that the financial statements are accurate, in compliance with accounting standards and that the profitability and financial position of a company are fairly presented in all material respects.

For example, in the situation whereby a key customer who represents 10% of a company’s revenue has provided notice of termination of a contract 30 days before year end there is likely very little disclosure, no impact to the “audit” report and certainly no adjustments to the profit or loss to be reported in that given year. Within a QofE report this issue would be flagged and the report would try to quantify the amount of profit that would not continue because of this customer leaving and point out that the reported EBITDA is not sustainable and needs to be adjusted downward by the contribution of the departing customer.

The things that a QofE covers includes, but is not limited to, the following:

• Revenue recognition
• customer and pricing trends
• collectability
• expense trends and normalizations
• working capital trends and related reserves
• inventory trends and obsolescence
• customer and supplier relationships and contracts
• employee and compensation trends
• tax liabilities
• unusual gains or losses among others.

CCC ensures that within its scope of work and preparation the sale process is prepared for the QofE process and its anticipated findings.  A well-run investment banking sale process will have already identified, normalized and positioned any possible findings that would come out of a QofE report to ensure that there are no surprises.    Therefore, the QofE becomes a corroborative aspect to due diligence.   Circumstances where a QofE report results in unexpected and negative findings puts significant risk on a deal closing.

When does it occur?

Typically, the QofE process occurs during the buyers’ due diligence after negotiating a letter of intent and entering into the exclusivity period that allows for comprehensive due diligence and drafting of legal agreements.   There is typically a significant information request brought forward by the accountants.  As a result, it is important that the seller and their investment banking advisors have anticipated this and have a data room full of information ready to go shortly after the signing of a letter of intent.

Although it is typical for the buyer to engage the accountants to perform the QofE process and draft the report a newer emerging trend is for the seller to engage an accounting firm to complete a “sell side” QofE and make the report available to all possible buyers.

Where does it happen?

The QofE process is integrated into the buyer’s regular due diligence stream.   As is occurring in most transactions, the information exchange is done online via secure electronic data rooms.  Responses to the QofE teams’ queries take the form of written responses, conference calls, video meetings and on occasion face-to-face meetings.

Why does it happen?

The QofE has become a more formalized and structured form of buyers due diligence.  There is a reason why this has occurred.   The QofE report has evolved into an independent verification of due diligence findings related to the target company’s sustainable profitability and cash flow.    It is the different stakeholders, such as lenders and investors, who are now relying on the report that have made the QofE almost a mandatory part of the M&A process.   Transactions that have a significant amount of debt financing almost always require a QofE by the creditors providing the loans.   It has become a requirement of the credit committees of those institutions and the findings are used in the credit decision.   Investment committees of private equity and other financial buyers are now also outsourcing the due diligence and use the findings of the QofE in their final underlying decision-making processes.

Impact on the Sale Process

Getting through the due diligence requirements of a QofE can be very detailed, complex and comprehensive.  Business owners who have not experienced this process before are well advised to seek the assistance of an experienced investment banker to help guide them and manage the sale process on their behalf.   CCC understands the requirements and reasons behind the QofE which allows us to help our clients coordinate and prepare for that form of due diligence.   It is critically important to have confidence that a QofE will result in only corroborating facts the buyer has already been informed of through key financial disclosure in the sale process prior to the start of the QofE.  Being prepared and having the right staff and advisor resources available will not only result in a QofE that validates the deal but it ensures that a successful transaction will be completed.

The team at CCC Investment banking would be happy to further discuss the sale process and how our investment banking services will ensure a smooth and successful sale of your business.

1. EBITDA means earnings before interest, taxes, depreciation and amortization.