Why More Sellers Are Using Quality of Earnings Reports for M&A Deals

Overall, sellers that used a sell-side QoE saw TEV/EBITDA multiples of 7.4x on average, com pared with 7.0x for those that didn’t undertake a QoE process. The bene fits were most notable for deals with enterprise values above $50 million, while smaller deals tended not to experience a valuation boost.

Although cost often deters sellers, an increasing number are opting for sell-side QoE to reveal risk factors early in the M&A process and flag areas for adjustments to increase the price of their business.

A Tool on the Rise

Like many trends in M&A, QoE first gained traction among large businesses and has since progressed down-market. That’s due in part to the clientele of investment bankers, who once focused on businesses with at least $5 million of EBITDA. For those businesses, sell-side QoE has become standard practice.

As investment banks began representing smaller companies with $1 million–$4 million EBITDA in recent years, they’ve encouraged those companies to undertake their own sell-side QoE, driving an uptick in use over the past three to five years. For smaller companies, which tend to have less-sophisticated accounting practices, the analysis can help reveal issues ahead of a sales process.

“Investment banks are saying, ‘You should get a sell-side QoE so that we don’t have any surprises later during buyer diligence,” says Michael Vaccarella, partner at Wipfli and leader of the firm’s Private Equity and Transaction Advisory Services team. The COVID-19 pandemic also contributed to the pick-up in sell-side QoE activity, as businesses dealt with shipping issues and supply scarcity. Many stockpiled inventory, leading to excesses when it came time to sell the company. They wanted to be compensated for those stockpiles, which weren’t reflected in EBITDA. “I think that spawned a lot more sell side QoE, because owners wanted to get paid for being advantageous with their inventory to meet demand and deadlines,” Vaccarella says.

Scott Linch, managing partner of Forvis Mazars Capital Advisors and the national sector leader of Forvis Mazars’ private equity practice, estimates that at least 90% of PE-backed deals he sees use a sell-side QoE. “It’s just part of their playbook,” he says. Smaller founder-led businesses without sponsor backing, however, are less inclined to pay for a sell-side QoE analysis. They often believe it’s unnecessary, especially if they’ve undertaken an audit or other review.

Although the usage has grown over time, Linch estimates that only about 50% of lower middle-market founder-led businesses commission a sell-side QoE. “We would like it to be 100%, just because of all the benefits it provides,” he says. Unlike an audit, there’s an operational angle to a sell-side QoE that explains how the operation really works and shows a fuller picture of what the purchaser is buying.

Vaccarella equates the audit to the town square in the “Wizard of Oz,” where the munchkins are singing. After that comes the QoE—the proverbial Yellow Brick Road on the way to Oz—when the “fun begins with EBITDA adjustments,” he says. “The sell-side QoE is supposed to bolster your adjusted EBITDA. That’s what everybody hopes for, and that’s where the valuation uptick comes in.”

Adding Value, Subtracting Risk

Earlier is better when it comes to beginning a sell-side QoE engagement. Linch and Vaccarella agree that three to six months ahead of a sales process is a good time to start. From an investment banking perspective, a sell-side QoE report can help benchmark the sales price and set accurate expectations for a seller. “They don’t want to go to market with an EBITDA number that can’t hold up through diligence,” Linch says. If the owner thinks he can sell for a certain price and later learns that figure is unrealistic, the revelation can kill the deal.

There are other risks that sell-side QoE can help identify early, such as incorrect revenue recognition or expenses from a lawsuit that weren’t recorded. Meanwhile, companies that opt to do tax diligence as part of the sell-side QoE process may find that they haven’t collected sales tax in certain markets where they have nexus, for example. Performed early enough, a sell-side QoE presents an opportunity to mitigate risks that could become an issue down the line when they’re identified by the buy-side during due diligence.

It can also be a way to uncover hidden value and position the company for a higher purchase price. “It’s not just a minus thing that people are worried about. They want to know about the pluses just as much or more than the minuses,” Linch says. “When you’re telling someone they should do [a sell-side QoE], one, you’re saying, ‘Hey, we want to know about the surprises or anything negative that might pop up, right? But two, [QoE engagements] should always pay for themselves. Because you’re hopefully finding positive add backs to EBITDA.”

A common source of add-backs are personal expenses that the seller is funneling through the business—a private plane or boat, for example. Those expenses won’t carry over into the new ownership and thus can be added back to the company’s EBITDA. Revenue recognition is another area where a sell-side QoE can inform positive adjustments. For long-term projects in commercial roofing, for example, companies should recognize revenue in line with the percent of completion, based on the cost. As costs are incurred, the business should recognize the revenue—but many, especially in the lower middle market, don’t track that information well, leading to inconsistent margins. A look-back analysis as part of sell-side QoE can smooth out those margins and paint a fuller picture of revenue.

Linch stresses the importance of working capital as another focus area during sell-side projects. Sellers are obligated to deliver a certain amount of working capital to buyers at closing. “If you’ve told them you’re going to deliver $100 and you deliver $80, you’re going to get a reduction in your purchase price by $20,” he says. “You’d rather deliver more working capital, and then the buyer has to pay for that.”

If it’s true that time kills deals, a sell-side QoE can provide a degree of life support for M&A transactions. Buyers will still conduct their own QoE analysis, but having the sell side report in hand can help speed things along. “Even on the buy-side, it’s great for me if there’s a sell-side [report] because I can get the package and look at it, and I feel like I’m 25% or 30% ahead of the game,” Vaccarella says. The sell-side report can identify specific areas for buyers to hone in on rather than starting from scratch. “If you can compress the diligence period, you hope that you can get to close faster,” he adds. “I’d say that over 90% of the time, it moves the deal faster than it would’ve [gone] without it.”

Katie Maloney is ACG’s Vice President, Communications & Content.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.