The Importance of Conducting a Quality of Earnings in M&A

Here is more on Andrew’s background.

I am in the transaction advisory services practices within Riveron. I’ve been doing transactions, which are mergers and acquisitions, financial accounting, and due diligence on and off for the last eight years of my career

Prior to that, I started out as an auditor at Arthur Andersen, which became KPMG, and I ended up working in the corporate restructuring practice. Shortly after that, I found myself doing mergers and acquisitions and transaction work, working with corporate buyers and financial buyers.

Our frame of discussion for today is around QoE since a lot of your experience is there. What would you say is the general purpose of getting QoE done?

QoE, or quality of earnings, is when Company A is trying to buy Company B. They are trying to validate the earnings stream of that particular company for the last two, three years, in order to understand the revenue stream, the expense stream, and what that means for the underlying company.

We do EBITDA, which is earnings before interest, taxes, taxes, and depreciation, and then start to think through one time, one-off events that would then give credence to the value that is being placed upon the company that is ultimately going to be purchased.

What would be some of the reasons for a seller to do a quality of earnings?

I think it’s in the seller’s best interest to do the quality of earnings analysis because it prepares them to understand what their true earnings potential is and what their historical run rate has been. It also mitigates the possibility of another firm coming in and doing a QoE only to find adjustments that they didn’t know about.

Doing a QoE puts the seller in an advantage to understand what their true quality of earnings is going to be and allows them to negotiate a higher and better return. If there are discrepancies there, the seller is well armed to understand that and explain it better to the potential buyer.

What do you think the buyer’s perception would be seeing a seller that has a prepared QoE versus seeing a seller without one?

The buyer gives them the assurance that a QoE has been done objectively. The QoE on the sell-side versus a buy-side should be the same if it’s applied consistently. When the seller sells, they may try to paint their business as the best business in the world. An outside firm is there to bring a needed level of objectivity.

However, even though everyone looks at the same quality of data, there can always be one judge that judges differently. The whole reason why you would do a QoE on the sell-side is that it gives you that sounding foot that allows you to understand what your business is going to be and how you can negotiate going forward.

When the buyer comes in and takes a look at it, that gives them credibility, allows them to move faster down that pathway of actually going through and putting forth a bid versus having to wait.

It’s still a good idea for the buying firm to do their own QoE to speed up the process. The importance of doing a QoE on the sell-side ensure that, that when the buy-side comes in to do a QoE, all the information is already collected, and you can get to a close a lot faster.

Does a buyer get a better deal in this QoE then?

It depends. When the buy-side comes in, the sell-side needs to update their financials, or the buy-side needs to roll that on their own. They should get a better pricing discount, however, they still need to go through and do a lot of the same analysis.

What happens is, you get an efficiency gain because all the information has been collected and put together. It should be done in a viable way, so you can document that data and make sure it’s right.

When do you get the buyers involved in the process?

You want to get the buyers involved in the process when everyone on the sell-side is completely onboard with selling the company and when you are certain that everyone in the sell-side is committed to actually sell, especially if it’s a family-owned business.

What are the biggest challenges for you, doing your own process?

From a financial accounting, due diligence process, probably the biggest challenge that we have is making sure that we have access to data, access to management, and making sure that we can communicate with management on this data. We put together a data request list, send it off to the target company, have them fill it out, and give us all the information.

We then take that information, crunch the numbers, and we are ready to go forth and have a conversation with the company. If our data doesn’t match or doesn’t add up to some of the reported numbers that they have, then we have issues. Sometimes, older companies don’t have upgraded systems, so we have to find different ways to move information.

All of that can be done, but there are always issues with transcription errors and such.

Is there anything specific in terms of getting the data that is challenging?

Sometimes there are system limitations where they can’t necessarily provide the data that we want. It could be that we want to understand particular margin trends, but the company doesn’t necessarily track that.

Another issue, for example, is when they don’t cost the underlying product properly. It all comes down to good data, access, understanding how the data rolls up, and making sure that we can take this data and turn it into information that can be used to drive the business and drive our clients to understand the business better.

Is there anything, in particular, that you do to overcome some of those challenges?

There are certain analytical procedures that we can do to make sure we can validate certain things, such as validating revenue, which is a common procedure that we do. We generally refer to it as proof of revenue, where we look at the actual revenues that are being reported, and we compare that to cash inflows that are coming into the bank statement.

We can also look at margins and we can maybe drill into margins per product line, depending on how detailed of analysis our client wants to do.

What are some interesting things that you’ve seen in your experience? What are some of the more extreme cases that you’ve come across?

I have seen home purchases that have been running through as acquisitions and land, but in actuality, it was an acquisition of a vacation home. A lot of adjustments are bonus-related, revenue recognition-related, where they may recognize revenue in one period and it’s not consistent, so you have to make adjustments for out-of-period revenue.

Sometimes you’ll see bad debt coming through and there are timing adjustments that you have to make. We have also seen unethical behavior, where money was being paid to other employees of different firms to entice them to use their services.

Those things we communicate to our client right away. For QoE, we are trying to remove one-time, non-recurring extraordinary items in trying to understand the business.

What does the business look like normally, without any type of calamity that has happened?

The loss of a large customer is something that you want to take out, which includes the revenue and the costs associated with that. All that would fall to the bottom line in order to try to get to the normalized quality of earnings.

What’s something you found that blew up the deal right away?

Unethical behavior is the first thing that causes me to blow up a deal, such as, for example,  enticing someone to hire you by giving them cash payments or selling something off the books.

These things raise suspicion and make you wonder what else is in the closet. If you are buying a business and the owner is staying, if that owner is not necessarily ethical, you probably don’t want him on your team and that’s a decision you need to make quickly.

I’ve seen situations where a business has over forty adjustments. The whole purpose of QoE analysis is to normalize, but if you have 40 independent, unique instances, it makes you wonder how is that business normal? The quantity of these adjustments can dictate that there is a high likelihood that something is wrong with the business.

Do you ever see that change? I own a small retail store. If I were to do a QoE, I’d probably have a hundred adjustments, versus DealRoom, where I have partners in the company and we keep everything spotless. What is your take on that?

I would say, most likely than not, those hundred adjustments can be probably grouped into one big category. In small companies, there are more adjustments, mostly because they are running personal expenses through, they don’t necessarily understand or have the time to do the accounting properly, and that, as a result, is going to drive different adjustments.

Would you see a difference in adjustments between single owners and multiple owners when approaching QoE? Will that fluctuate depending on the company size or the industry they are in?

Definitely. It goes back to the quality of data and how the data comes out of the system and how you can take this data and turn it into true information.

Turning numbers into information, validating them, giving them credence, and then turning them into a real viable product that shows what this company has done over the period that we are interested in looking at - that becomes your analysis.
‍

You can have a small company that has three adjustments and you can have a large company that has seventy-five adjustments.

If you look at the way the technology is evolving and changing, how do you see it changing the QoE process?

I think that, as you get better accounting systems, better technology, better inputs, and outputs, that will drive efficiency and if you can drive efficiency, that makes your ability to kick the numbers faster.

What are some of the key lessons that you’ve learned that you could share with listeners and young QoE practitioners?

The key lesson is to always be objective, always question, and always look for support. Make sure you understand exactly how things roll up and how things add together.

Try to put yourself in the buyer shoes, in the seller and advisor shoes in order to understand what their objectives are. Never waver, always be objective and never side on either side, but always try to stay in the middle.

Ask the same question two or three times, because every time you might get a different answer, as at first people may give you the answer that they think you want to hear, but later that answer can change. Financial information just numbers on the page, so always make sure you validate them by going on the spot to see for yourself and make sure you talk to the right people and ask questions.

Ending credits

Thank you for taking the time to explore the world of M&A with our podcast.

Please subscribe for more content and conversations with industry leaders.

If you like our podcast please support us by leaving a five-star review and sharing it.

M&A Science is sponsored by DealRoom, a project management solution for mergers and acquisitions.

See you next time!