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Episode 16!           

Punching Out! What is a Quality of Earnings Report?

April 03, 2020 12:00 PM | Judy Pfeiffer (Administrator)

Contributing Author: Tom Kastner, President, GP Ventures

Tom is the president of GP Ventures, an M&A advisory services firm focused on the tech and electronics industries. Tom Kastner is a registered representative of and securities transactions are conducted through StillPoint Capital, LLC—a Tampa, Florida member of FINRA and SIPC. StillPoint Capital is not affiliated with GP Ventures. 

For the past several years, Quality of Earnings Reports, also called ‘Q of E’ Reports, have become more popular in M&A deals.  Whether the seller’s financials are audited, reviewed, compiled, in QuickBooks, or on the back of a napkin, a Q of E report helps buyers become more comfortable with the seller’s numbers and identifies risks in the business.  Until recently, these reports were mostly completed for larger deals, but lately they have been performed for companies at $10 million in revenue or below.  The reports are for a specific M&A deal, performed by a third-party accounting firm, and usually take a few weeks (2-4 during off-season, 4-8 during tax season) to complete.

Q of E reports are almost standard for all public and private-equity buyers for deals above a certain size.  This is to provide a third-party analysis and review of the seller’s financials and the structure of the deal.  Third parties are independent and have no stake in the game, so they are generally unbiased and not influenced by any pressure to do a deal.  Public company boards of directors and private equity investors typically insist on getting these reports, not only for their independent analysis, but to provide another prospective on the deal that the buyers may have missed (in other words, ‘CYA’).

The Q of E provides analysis into the ‘quality’ of earnings, that is, how sustainable are revenues and earnings, and how realistic are the seller’s projections.  Depending on the scope of the report and the buyer’s concerns, the Q of E team can look into a wide range of topics.  For example, if the seller’s customers are mostly well-financed blue-chip companies, revenues are based on long-term contracts or repeating programs, and revenues have climbed steadily, those earnings would be generally ‘high quality’.  However, if customers are mostly smaller companies, orders are lumpy or spotty, there are a lot of one-time orders, suppliers are small and overseas, the equipment was purchased in the 80’s, and revenues have been up and down, the Q of E team would probably rank those earnings as lower quality.

The Q of E report also looks at the quality of assets, various accounting policies, the quality of the supply chain, financial controls, the level of the management team/financial reporting, IT systems, and a wide variety of other factors.    The scope of the report depends on the concerns of the buyer and the complexity of the business.   The costs also depend on those factors and can range from around $25K for a limited report to up to $100K for a complex report for businesses in the $10-100 million range.

In recent years, sellers have become more proactive and have requested Q of E reports on themselves.  This is a bit like getting a home inspection completed before selling a house or getting the mechanic to check out your car before you sell it online.  Getting a sell-side Q of E report gives buyers confidence early on, uncovers issues, makes the process quicker, and is a strong signal that the seller is serious (and wants a serious value for the company).  Sell-side Q of E reports are becoming standard, so not having it puts the company behind other sellers.  If something negative comes up, you can hit the ‘pause’ button and fix it before going to market, or at least disclose it in advance and avoid any surprises.  Sellers who are thinking of going to market in a few years could get a report done now, then have plenty of time to correct any issues.  A re-fresh of the report when the company is ready to go to market should be easier and less expensive than the original report.

As an owner or executive of a company, you have worked there for years, so you understand the business well and have accepted all (or at least most) of the risks of the business and industry.  Owners can get blinded by familiarity, and they all think their babies are beautiful.  Buyers may come from a slightly different part of the industry and may organize their business differently. Private equity or other investors may not know the industry well.  A Q of E report can give the owners and executives a perspective of the business that they otherwise would not receive.

Who pays for the Q of E report?  If it is a sell-side Q of E report, the seller pays, but it typically pays off in higher valuations and a smoother deal.  If the buyer asks for it, the buyer typically pays.  However, some buyers may say that the seller has avoided paying audit fees for years, so the seller should at least pay half.  For companies under $10 million in value with relatively simple organizations, a Q of E report may be overkill, but it is recommended for larger companies with more complex organizations.  If the buyer requests the Q of E, it is almost always after a Letter of Intent is signed and the parties have entered into an exclusive due diligence period.

The main differences between a financial audit or review and a Q of E report are that audits check to see if the financials conform to GAAP and they are backward-looking.  Q of E reports take into account add-backs, a variety of risks, and also cover forward-looking projections.

A great Q of E report can help support a higher valuation, better terms (more cash at closing, less earnout), a smoother negotiation and due diligence process, and better reps and warranties terms (or lower Reps and warranties insurance premiums).  It can help the buyer with their financing efforts and help them get approval from their board of directors or investment committee.  A Q of E report does not replace buyers’ due diligence, but it can be a very important independent tool for understanding the business.

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