"Q of" What?
Middle market M&A transactions oftentimes require the production of a report called a “quality of earnings” analysis. Most people, businesspeople or not, have never heard of this, and business owners, upon hearing that they will need one conducted, often have the response that is the title of this article. So what is a quality of earnings report, or “Q of E” in shorthand? In simple terms, it’s an analysis performed on a business’ financials to ensure that the financials were assembled appropriately from a Generally Accepted Accounting Practice (“GAAP”) perspective and equally as important, to ensure that from an analytical perspective (which can be different from an accounting perspective) the financials are telling the appropriate story about the state of the historical financials. In the context of an M&A transaction, there are a couple things of note regarding Q of Es.
- Many middle market businesses (especially those that are owned by founder / entrepreneurs versus private equity firms) do not have audited, or even reviewed, financials. As such, the Q of E, while not explicitly intended as a substitute for an audit or a review, is oftentimes the first “professional financial review” a business has ever received. As such, inevitably, some inaccuracy is uncovered and as we investment bankers like to say, “forewarned is forearmed.“ In other words, while we can’t turn back time and necessarily correct an inaccuracy in the past, we can, however, identify it upfront and devise a strategy to explain or mitigate against it as all sophisticated potential buyers will, in all likelihood, identify the same inaccuracy
- A Q of E report is oftentimes oriented around defining the true Earnings before Interest, Taxes, Depreciation and Amortization (“EBITDA”) for the last 12 months (“LTM”). LTM EBITDA is a common financial metric around which many middle market businesses are valued. Moreover, EBITDA is not a GAAP accounting term and as such, even if the company is audited or reviewed, you will not find a line item labeled “EBITDA.” Additionally, company audits and reviews are conducted around the fiscal year end. Most M&A transactions do not occur entirely in line with the fiscal year end such that an LTM view is oftentimes more up to date than the last audit or review.
- Particularly when private equity is the presumed acquiror or investor in a business, they will oftentimes deploy debt (or “leverage”), in addition to their own equity, to fund the investment (the “L” in “LBO” stands for “leverage”). Lenders, particularly traditional chartered commercial banks, operate in highly regulated environments and as such, require volumes of documentation and representations of accuracy. A Q of E is required by most lenders.
Q of Es have long been required by buyers of or investors in businesses (particularly when they are PE firms). Given the above, we, as investment bankers, are increasingly suggesting that our clients commission their own Q of E before entering the market. A nationally recognized, reputable accounting firm can produce a Q of E anywhere from $50,000 to $75,000. While the Q of E is a real cash expenditure, it will be treated as an addback to EBITDA. More importantly, the benefits of being proactive on the Q of E front provide several large advantages as the M&A process unfolds in that it allows for the buyer to more expediently move through their due diligence and again, “forewarned is forearmed.” Sellers hope to be viewed as good investments, and in turn, the Q of E is a good investment to help ensure that.