Preparing for due diligence in a business sale

Financial Scrutiny. In recent years, the financial focus of buyers has risen to new heights by the growing use of a “quality of earnings” (QofE) review, which we referenced above. Such reports are increasingly common in larger transactions, especially where the buyer is a private equity firm.

“A quality of earnings report is a deep dive on the seller’s financials,” said Matt Frye, a partner in IBG Business’s Oklahoma office. “It shows a buyer the business’s true profitability by adjusting EBITDA to reflect any non-recurring revenues and expenses. Likewise, a QofE identifies liabilities and how they might be factored into the working capital calculations.”

Investopedia puts it less delicately, noting that a QofE report reveals a clearer picture of earnings “by dismissing any anomalies, accounting tricks, or one-time events that may skew the real bottom-line numbers.”

When the “real bottom line” deviates too much from the financials offered up by the seller, the QofE report can drive a wedge between the parties, injecting new challenges to due diligence and putting the deal at risk.

As threatening as that may seem to a seller, IBG’s M&A professionals view a QofE review as consistent with one of their standard practices in packaging a business for sale.

“We routinely recast the business’s financial statements to show its true earnings in a form that buyers expect,” said Frye. “While it doesn’t rise to the level of a QoE review, our in-depth recasting, before the company goes on the market, can strengthen the package we present to buyers and possibly lessen the need for the buyer to initiate its own review.”

Frye’s IBG colleague, John Johnson, adds: “We pave the way and anticipate issues. A top M&A intermediary will have prepared the client to sail through the QoE part of due diligence. Much of the advance process is routinely handled by the client’s M&A advisor, whose analysis minimizes the ‘surprises or difficulties’ arising from the buyer’s subsequent QoE work in due diligence.”

In some deals, a recasting will not meet the buyer’s needs, and the buyer might commission its own QofE review, absorbing all of the cost or asking the seller to share in it. If the seller and their M&A advisor anticipate that the buyer will require a review, there are instances in which it’s in the seller’s interest to have it done in advance. That can make a good impression on the buyer, reduce buyer requests for financial information, and shorten the due-diligence phase.

The benefits to the seller may not end there, Frye noted. He cited a white paper by Whitley Penn that contends that “every nickel spent on a QofE turns into a dollar”:

“A sell-side Quality of Earnings often results in a higher sales price for the company. Because M&A transactions are valued as a multiple of earnings, the higher the earnings the higher the value. The sell-side QofE team will likely uncover certain expense adjustments that would be considered addbacks to EBITDA to increase profitability which will then be multiplied by a market-based multiplier to calculate the transaction value.”

“Because QofE reviews are more the rule than the exception in the upper echelons of deals,” said Johnson, “we expect them to become more commonplace in mid-market transactions as well. Sellers need to be prepared for buyers to initiate the review, which can extend the due diligence phase.

“Under certain circumstances, sellers might consider the possible benefits of commissioning a review on their own, but the reality in most deals is that neither the buyer nor its bankers and investors are likely to accept seller-commissioned work commissioned as a substitute for their own review.”