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Selling Your Company? Make the Most of It With a Quality of Earnings Report

September 13, 2019

One of the most significant career events for a business owner is selling his or her company. The stakes are high, and a financial payout is on the line. While an audit or review of the company’s financial statements confirm that management has presented the financial position and results appropriately, they won’t identify key risks and issues that will interest buyers.

That is where a sell-side quality of earnings report comes in. Not only will it convey key information to buyers, it can help preserve value, increase certainty of closing, decrease the time to close, and reduce surprises in the process.

A sell-side quality of earnings report – sometimes referred to as sell-side due diligence – is really an invitation to a seller’s financial information. For many owners of private or family-owned businesses, the only financial information that they have been required to disseminate to other parties is a compiled, reviewed, or audited financial statement – if anything. If a business has no debt, and subsequently no financial reporting requirements, it’s possible that no one outside of the ownership group has been provided access to financial information.

When bringing your company to market, it can be uncomfortable to have to share financial information with outside service providers, including an accounting firm. However, the benefits are significant and can help almost every party throughout the transaction process, including the investment bank, owners, lenders, and potential buyers.

But what is a sell-side quality of earnings report, actually? It is a presentation of a company’s recent financial results (typically two to four years’ worth) and focuses on several key areas:

  • Normalized Quality of Earnings Analysis

Buyers are interested in the financial results of the business, which are typically measured by the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA). A sell-side quality of earnings analysis helps a seller understand and adjust their financial results for non-recurring items, non-core expenses, pro forma adjustments, and other accounting adjustments.

  • Non-Recurring Items: These are one-time items, professional fees, fixed asset sales, and other items that are not to be expected in the future. These items can be easy to think through, such as related-party transactions, or more difficult, such as overhead costs that would not be incurred post-transaction.
  • Non-Core Expenses: Non-core expenses are personal in nature or unrelated to the business that is being marketed. Since entrepreneurs often own multiple businesses, it is not uncommon for the profitable business to fund operations of the other businesses.
  • Pro Forma Adjustments: Pro forma adjustments relate to impending changes in the business that will take place post-transaction. Examples of pro forma adjustments include changes in management compensation, additional members of management expected to join post-transaction, and vendor agreements or customer relationships that are not expected to continue.
  • Accounting Adjustments: It’s very common for smaller businesses to use the cash basis of accounting since the accrual method can require additional time, effort, and accounting resources. However, private equity buyers want to see the financial results according to accounting principles generally accepted in the United States (U.S. GAAP). During a sell-side quality of earnings analysis, the financials are converted to U.S. GAAP to give a more uniform view of the company’s financial position.
  • Key Financial and Operational Trends: This section gives management an opportunity to expand on the company’s earnings, addressing market drivers and other factors influencing the company’s performance. This gives potential buyers deeper information on revenue streams and cost structures.
  • Working Capital: During a transaction, the seller agrees to provide a certain level of working capital to the buyer at closing. The sell-side quality-of-earnings report provider, typically an accounting firm, helps the seller develop a working capital target by considering working capital trends, potential non-GAAP issues, seasonality of the business, and other factors. If inaccurate assumptions are used in setting a working capital target, it can be costly – from a time and financial perspective.
  • Debt and Debt-Like Items: All debt and debt-like items should be disclosed in a sell-side quality of earnings report since this will be a focus for the buyer. This requires a deeper dive into certain lease agreements to ensure that capital leases are appropriately disclosed.

What Are the Benefits of a Sell-Side Quality of Earnings Report?

A sell-side quality of earnings report is an investment, but it is one that can help create value while expediting the transaction process. All deals are different, but the following are several key benefits of a sell-side quality of earnings report and the due diligence process.

  • Providing Credibility for Earnings: Many businesses up for sale have either never undergone an audit or else provide financials that do not align with the period that has been audited. Sell-side due diligence providers will often perform certain audit-like procedures to give credence to key financial numbers such as revenues, gross margin, and the cut-off expenses. For example, a high degree of credibility is added to the revenue number when cash provided by customers is reconciled to the revenues recorded in the general ledger during the same period.

Additionally, businesses with a competitive advantage may have a product or service line with a considerably higher gross margin than competitors. It’s helpful for the sell-side due diligence provider to verify these metrics so that the buy-side due diligence provider cannot prove otherwise and potentially reduce the purchase price.

  • Adding Deal Value: Having well-thought-out and supportable pro forma adjustments is one of the best ways for a seller to add value to the underlying purchase price. It’s important to articulate the thought and logic to all parties since the pro forma adjustments will need to withstand the court of buy-side due diligence opinion.
  • Organization of Data:  Private companies with multiple subsidiaries, divisions, and products often do not track information on a granular level. However, buyers are interested in financial metrics at the subsidiary, division, or even stock keeping unit (SKU) level. The sell-side due diligence provider can help organize data so all parties can understand the company’s financial performance at various levels, including the following:
  • Customer-level information (profitability by customer)
  • Segment-level information (profitability by division or segment)
  • Country-level information (if country-specific information is available)
  • Channel-level information (if the business is a distribution entity)

A well-organized data book also helps the investment bank expedite the confidential information memorandum, which is used to market the company to prospective buyers.

  • Proactively Addressing Potential Issues: It’s common for there to be potential issues related to the quality of accounting information provided by the seller. Some issues, such as calculating accruals at certain period ends or resolving other cut-off issues, can be solved relatively quickly, but other issues require deeper attention.

One of the most common accounting issues for private companies is the lack of an inventory costing process. Sell-side due diligence can help the company create assumptions needed to recast financial information so that gross margin and cost of goods sold are properly reflected. Sales tax is another area for potential issues. The sales tax landscape is consistently changing, and the South Dakota v. Wayfair case has created significant nexus in states where it may have not previously existed.

Because buyers often base the structure of their deals on the potential liability exposure they could be inheriting, it’s important for sellers to be forthright about these issues. A quality of earnings report can help sellers preemptively address issues that typically slow down the transaction process or stop the deal process entirely.

  • Preparation: By going through the sell-side due diligence process – including meetings, data requests, and a deep dive into the company’s operations and finances – the seller and investment bank are more prepared for what to expect from the buy-side due diligence process. It’s not uncommon for sellers to undergo buy-side due diligence multiple times, and the buy-side due diligence provider is often under time constraints if a letter of intent has been signed. Having been through a dry run previously helps ensure the seller is adequately prepared.
  • Defender of Positions: There are often judgments made in the quality of earnings report around accounting estimates and diligence adjustments, specifically pro forma adjustments. By having a sell-side quality of earnings analysis conducted, a seller has a third-party advisor to defend and articulate positions taken in the report if they are brought into question by a buyer.

A sell-side quality of earnings report can create value while helping pave the way toward a smoother transaction. If you are considering selling your company or have questions about the process, our team of transactions experts is here to help.

Mike Wipper Partner, Transaction Advisory Services

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