By Jeff Stamm
Despite the global COVID-19 pandemic, interest rates remain at record lows and private equity funds are flush with available capital to pursue acquisitions. This perfect storm can be a boon to small and medium-sized business owners looking for an exit strategy or new opportunity to cash out. To do so, however, requires owners to undergo a more rigorous internal review of financial operations than they have done with annual financial statement audits or reviews.
Now is the time to prepare for a potential buyer or investor’s inevitable questions: is your business’s recent profitability sustainable going forward and can you prove it? Or, if you believe recent profitability is artificially low for various factors (e.g., COVID-19) that you don’t want to negatively impact your valuation on a potential sale, how can you support asking a potential buyer to ignore recent experience and use historical and/or forward-looking results to value your company instead?
A sell-side Quality of Earnings report (QoE) can help you, the seller, understand your business from the buyer’s perspective by accumulating and analyzing financial data in the same manner as a potential buyer would. By taking this approach, any potential issues that may negatively impact business value can be identified in advance and allow business owners enough time to take corrective actions and/or devise a game plan on how to best address such issues when they ultimate arise during a buyer’s diligence period. Identifying such issues before your buyer and having a plan in place to address will likely accelerate the due diligence process (reduce time to close) and possibly increase your selling price.
The purpose of a Quality of Earnings report is to model the business’ performance by distinguishing between reliable income and those factors that have impacted the business’ cash flow, positively or negatively, that are not repeatable or sustainable over time.
A QoE presents financial trends and analysis over a historical, typically 36-month period, in a straight-forward, standard format that private equity groups, corporate investors, and/or bankers can rely on as a baseline to then project expected future cash flows of the business and determine an appropriate valuation. Understandably, investors and lenders would be uneasy if they were only able to review annual audits and would require more work on their end to understand past financial performance prior to determining the value of your business. Let’s learn why.
Audit vs. Quality of Earnings Report
Audits are essential tools for businesses to verify their annual performance. This yearly reflection provides business owners with a level of assurance that the business’ financial statements are consistent with generally accepted accounting principles, or GAAP. By definition, such reviews are retrospective, and while they do reflect actual results for Net Income under GAAP, they do not explain variability in financial performance from year-to-year in great detail, nor do they consider potential changes in profitability that might result from a transaction, nor adjust for one-time items that might have impacted historical performance but do not appropriately reflect the business’s expected cash flows on a run-rate basis.
For example, if a business receives a $1m payment for a favorable lawsuit settlement in 2019, that amount will be recorded as income in the audited or reviewed financials; however, an investor cannot expect to receive that $1m settlement on an ongoing basis and will want to remove that income for purposes of valuing the business.
To give another example in which an investor might want to increase earnings for their valuation – if there are family members of the owner on payroll whose business functions may not be essential to ongoing operations, the payroll expense will reduce earnings for purposes of a review or audit, but as part of a QoE process these costs would be removed to present the higher, more accurate earnings potential of the business without the burden of personal or other non-operating costs reported within Net Income.
A Quality of Earnings report addresses these inherent disconnects between historical results as presented in audited or reviewed financial statements and the annual cash flows an investor should reasonably expect to generate under their ownership going forward by focusing on determining a normalized level of EBITDA for the business, rather than a GAAP-basis Net Income amount.
As a business owner, you know the context and reasons for differences in annual performance, but a potential investor needs to factor in those exceptions to determine the true earnings of the business.
EBITDA (Earnings before interest, taxes, depreciation, and amortization) is a more relevant metric than net income for purposes of valuing a business; as it provides a clearer view of cash flows an investor might expect to achieve under their ownership.
Earnings – Reported Net Income, as presented in your review, audit, or internal financials if no review or audit has been performed historically.
Before, or Less: In order to evaluate potential earnings, investors remove or “add back” the following expenses from Net Income:
Interest – Most transactions are consummated on a cash-free, debt-free basis. That is, as a seller, you keep any remaining cash on hand but must settle any existing debt obligations at close. A buyer will likely obtain their own financing to purchase the business, the terms of which (total balance owed, term, interest rate, etc.) will be different than the interest expense paid by the business historically. Therefore, buyers need to evaluate earnings “before” or “without” interest expense as they will input their expected interest expense under the new debt facility into their valuation model as it more accurately reflects their future cash flows.
Taxes – Buyers typically contemplate a new legal entity structure when purchasing a business and/or plan to roll the acquired business under an existing entity post close. As legal entity structure (and other factors, e.g., amount of interest expense) can cause significant variability in tax expense, a buyer will evaluate the business “before” or “without” the burden of historical tax expenses as they will estimate their own expected future tax expense within the valuation model.
Depreciation & Amortization – Buyers remove depreciation and amortization as these expenses relate to purchases (cash expenditures) made in prior periods that are being reported as expense in the current period. Including these expenses would result in understating cash flow in the current period. Buyers will analyze historical capital expenditures and equipment purchases separately from EBITDA to determine an annual cash flow impact from equipment or other asset purchases needed to support the business on an ongoing bases.
Business owners interested in preparing their companies for potential acquisition are best served by engaging a business advisor who is a CPA that has counseled both buyers and sellers in mergers and acquisitions to provide balanced, strategic advice that includes the buyers’ perspective.
Once you understand the historical financial results of your company through the same lens as potential investors, you will be well-positioned to negotiate a fair sales price and well-prepared to provide all of the supporting data a buyer will request during diligence to help prevent delays in close timing and/or potential value-impacting issues to arise during diligence that could cause the buyer to walk away or revise their purchase price to an amount that is no longer acceptable for the seller.