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The Smarter Startup

Surviving Due Diligence, Part 4: Quality of Earnings

Preparing a Quality of Earnings (QoE) report is a valuable step a startup can take before entering substantial due diligence with a buyer.

Welcome to the fourth installment of our Surviving Due Diligence series, a collection of best practices and tips to help startups successfully get through the due diligence process that precedes most financings and exit transactions. Burkland CFOs have seen all types and sizes of exits, and have performed countless hours of due diligence work on behalf of our clients. We’ve seen what works, what doesn’t, and what helps the process go smoothly and efficiently.

When it comes to exits, one of the valuable steps a startup can take before entering into substantial due diligence with a buyer is the preparation of a Quality of Earnings report, or QoE.

What is a Quality of Earnings Report (QoE)?

A QoE is usually prepared by an independent third-party accounting firm and essentially validates and normalizes the company’s earnings to account for any add-backs and other details. The goal is to cleanly illustrate the company’s “actual” earnings power post-close, once you’ve adjusted for all sorts of non-recurring anomalies, non-cash items, accrued costs, and accounting policies that may be skewing your reported numbers.

In recent years, sellers have increasingly commissioned “sell-side” QoEs, and for a number of very good reasons.

QoEs have been around for a long time, but until recently, they were usually commissioned by buyers as a “buy-side” exercise as part of their due diligence process. This is no longer true. In recent years, sellers have increasingly commissioned “sell-side” QoEs, and for a number of very good reasons.

5 Reasons to Consider a Sell-Side QoE:

  1. Since a QoE verifies details like EBITDA, revenue recognition, adjusted cash flow and go-forward balance sheet items like net working capital, having them already in hand when the buyer’s due diligence begins can dramatically reduce uncertainty and speed up deal timelines.
  2. QoEs help anchor valuation conversations as they provide a window into what the company is actually worth. Having a QoE in hand makes it much less likely a buyer comes back to you after due diligence with a big adjustment to their initial offer.
  3. Trends in growth, profitability and margins are scrubbed and analyzed by an independent third party, helping you expand your understanding of key drivers of (and fluctuations in) the business and arming you with the right information to discuss with potential suitors.
  4. Related to #3, it is much better to have surprises or errors uncovered by you first and not by the buyer’s diligence team. The former gives you an opportunity to make corrections or frame narratives internally with a team that’s on your side; the latter leaves you red-faced and usually results in adjustments to the price or, in extreme cases, derails the deal completely.
  5. Related to #1, a sell-side QoE also preps your finance and management teams for the buyer’s due diligence process, which if you’ve never been through one before, puts a whole new meaning behind the word “meticulous.” Your team is better equipped, in terms of both information and familiarity, to tackle a buyer’s questions quickly and efficiently.

What to Expect When Commissioning a QoE Report

So what does a QoE look like mechanically? As noted earlier, the work is usually performed by an unbiased CPA firm and, depending on size & complexity, can take 2-4 months to complete. Typically, a company interested in a sell-side QoE will send out RFPs to a number of firms (we suggest at least three) to get bids on the work.

Costs can range widely; many of the sell-side QoEs we’ve seen are in the $30-$50K range (which is in turn added back to EBITDA as part of the QoE). Note that cheapest is not always best – check to make sure your provider will provide both a narrative analysis and a workbook with all supporting spreadsheets. Also, inquire whether a “pull-down” is included in case you need to include an additional period, like the next quarter – deals can take longer to close than expected. Importantly, ensure the relevant individuals on your team, particularly in finance, can carve out time to prioritize the QoE process – answering questions on a timely basis, preparing schedules, being available for meetings, etc.

QoE vs. Audit, What’s the Difference?

One question we’re often asked is how a QoE differs from an audit. Both are valuable from a due diligence perspective, but there are important distinctions between the two:

  1. An audit is looking to verify your financial statements comply with, and are presented in accordance with, GAAP; a QoE is looking to adjust those statements (also in accordance with GAAP) to best reflect the company’s true profitability and key metrics.
  2. An audit’s focus is skewed towards the balance sheet; a QoE is more focused on the P&L.
  3. An audit is typically looking at fiscal year periods; most QoEs will analyze the company from a rolling 12-month perspective in addition to a historical lookback (usually three years).
  4. An audit is governed by materiality standards, including internal controls, that may be well beyond the scope of a QoE.

While it may seem like a daunting task, preparing a sell-side QoE is probably one of the most impactful steps any company considering an exit transaction can take. Due diligence is a necessary, exhausting, and difficult part of any M&A deal; a sell-side QoE gives you and your company the benefits of a dry run beforehand, more confidence in your valuation, and ultimately, a cleaner, faster and more successful close.

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