If you’re buying a small business, you need to know if the financials the seller gives you are accurate. Do the numbers paint a clear picture of how this business makes money and how much net profit it generates, or is it a warped view?
To find out, smart buyers commission a Quality of Earnings (QoE) report. The QoE report provider investigates the reality behind the figures. Then, they make adjustments to the financials as needed. The buyer gets a better sense of what this business will likely earn, post-sale. And that’s what business buyers need to make smart decisions.
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What is Quality of Earnings?
Quality of earnings measures sustainable free cash flow in a business. Sellers will disclose their earnings before income taxes, depreciation and amortization (EBIDTA), but their calculations may not tell the whole story.
The quality of earnings report helps you understand the seasonality or variability in the business, the working capital needs and capital expenditures. Income and costs will be examined to see if they’ll realistically continue, or were a one-time blip. Some businesses saw a spike or a decline during the pandemic, for instance–projecting that forward would give a false impression.
To sum up, the quality of earnings report offers critical insights on how the seller’s business model works–and how it might work for you, if you bought it.
Why Do You Need a Quality of Earnings Report?
The quality of earnings report is important because it reveals whether you’re getting the straight story from your seller. QoE research will turn up such things as:
- One-time revenue portrayed as recurring
- Ongoing costs portrayed as unusual expenditures
- Double entries and other errors
- Use of ‘creative accounting’ to obscure problems
Big companies routinely do QoE reports when they seek to acquire a company–but in a way, small-business buyers need quality of earnings reports even more.
Here’s why: Smaller businesses tend to have less robust accounting departments. They may not necessarily be in compliance with all national accounting standards–in fact, accounting may consist of an unaudited Excel spreadsheet the business owner typed up for the sale, notes Elliott Holland, partner at the due diligence services firm Guardian Due Diligence in Atlanta.
In other words, there are likely more problems lurking in a small business’s monthly profit-and-loss statements than there are in a larger company’s figures. The QoE report brings that small-business owner’s accounting into line with accepted standards. This helps detect problems and determine what, in fact, is sustainable growth and earnings at this business.
Fudging the numbers
Labor is the biggest expense in many business models–which means it’s an area ripe for creative accounting. An example from Holland’s practice:
Researching one online professional-services business that was being sold by an owner of multiple businesses, Holland was told the business for sale had a team of seven full-time employees. Looking at the websites of the owner’s other businesses, Holland discovered the team was actually working in all of the owner’s businesses, with their full salaries spread between the various businesses.
That meant the team really earned three times what was disclosed, and they weren’t devoting full-time hours to the selling business. Replacing the team post-sale with actual full-timers would cost far more than the seller reported as team salaries.
Lenders require QoE
While a Quality of Earnings report is always advisable, if you’re financing your business purchase, it’s often required. If you’re seeking a business loan from a private bank or trying to secure an SBA loan, your lender may be unwilling to move forward without a Quality of Earnings report.
Finally, the adjustments in the quality of earnings report will affect the business’s valuation. You may end up overpaying if you simply rely on the seller’s financial statements.
“What you want in a quality of earnings report is to get up the learning curve,” says Ben Bryer, managing partner at the business-investment and advisory firm Highspire Holdings in Westchester, Pa. “You want to know enough to see if you want to continue with the transaction.”
What Does a Quality of Earnings Report Cost?
Now that you know what a quality of earnings report is and why you need it, the next hurdle is getting this report done affordably. Much of the QoE work for larger business merger and acquisition deals is handled by major legal or accounting firms.
The drawback? These firms charge an arm and a leg for creating a quality of earnings report. Investment bank SDR Ventures estimates $20,000-$80,000 and up for a detailed quality of earnings report, for instance. These costs won’t be affordable for buyers in many small-business acquisitions, as a fee for just one aspect of the complex due diligence process.
As a small-business buyer, your best option is to find a qualified provider who is a solo practitioner or boutique-firm operator. A quality of earnings report through an independent provider runs roughly $5,000-$20,000, says Bryer. Your exact fee will depend on your risk tolerance, how much investigation work you want done, and the complexity of the business you’re buying, he says.
Note that some QoE providers charge hourly, while others charge by the project. There are advantages to each method–but in either case, resist the temptation to cut off a QoE investigator before they complete their report. The final 15 percent of the investigation is often what turns up the most explosive facts, Holland notes.
How to Find Quality of Earnings Help
You’ll want to find a provider you can trust for this important area in due diligence. A referral from another buyer who has used the provider would be ideal, Holland says. Don’t rely on a referral that’s simply, “I’ve heard about a guy who could do that.”
Short of a direct referral, look for providers on platforms where there are rankings or recommendations, and you can get a sense of what past customers thought of this provider. The DueDilio network offers both, though you can glean some recommendations from scanning LinkedIn profiles, or even from a sophisticated Google search.
Questions to Ask a Quality of Earnings Report Provider
When you locate a possible provider, interview them to see if they’re a fit for your particular business purchase situation.
What do you need to find out, to see if this provider is right for you? Here are a few fundamental questions:
How did this provider learn to do QoE reports? How long have they been producing them? How many have they done? This is their chance to share any big-accounting or major law firm experience they may have doing QoE on bigger deals in the past, or to otherwise explain how they came by their expertise.
“There are lots of things you can only pick up on through experience,” says Bryer.
One problem Bryer’s experience recently helped him uncover: Researching a sheet-metal fabrication company, he learned that new cybersecurity laws required a substantial investment to fix their websites. Nothing had yet been done to comply, and the cost wasn’t accounted for in any of the seller’s financials.
What degrees or certifications do they have that support their being qualified to do QoE reports? Is due diligence work a major part of their practice, or an occasional sideline? Do they continue to take courses to stay up to date on best practices?
Bryer, for instance, is a Chartered Financial Analyst (CFA), a fairly rarefied post-graduate certificate typically earned through 300 hours of advanced study. He also formerly oversaw $18 billion in structured (market-linked) investments at Vanguard, one of the top global investment firms.
Any good provider should be able to give you a sample report they’ve produced. It’ll give you a sense of the types of problems they uncover. You’ll also see if they present their findings in a way that’s easy for you to understand, Holland says. If it’s all dense accounting-speak, you may be left confused.
Similar business type
One important question is whether this provider has done QoE on similar types of businesses. The quality of earnings report for an ecommerce business will be entirely different from a report for a pool-maintenance service business, Holland points out.
Over the years, experienced providers learn the important questions to ask in a particular business type–you don’t want to be their first foray into a new business arena.
Get an Affordable, Accurate QoE Report
As you’ve learned, getting a quality of earnings report is vital to keeping business buyers well-informed. With the tips above, you should be able to find a qualified provider and get your QoE done within your budget.
Let your QoE pro go where the research takes them, to find what’s hidden, Byers says.
“It’s not ‘I just need my QoE work for EBIDTA adjustments,’” he says. “That’s not it. If that’s your thinking, you’re strapping yourself to a time bomb. You won’t understand this business that you’re buying very well.”
With a detailed, fully researched QoE report in hand, you’ll have a much better idea of whether the business you’re looking at is correctly valued–and whether you still want to buy it.