12 Dec Leveraging Quality of Earnings Reports in M&A Transactions
Mike, Ryan and Matt from Revenue Rocket discussed the importance of a quality of earnings (QOE) report for IT services firms in the context of M&A transactions, highlighting that it is a comprehensive financial analysis that can provide third-party validation and help streamline the acquisition process. They also explored the benefits of Revenue Rocket offering QOE services as an independent tool to gain market visibility and access to potential buyers and sellers.
Key points
- Quality of Earnings (QOE) report is a detailed financial analysis that certifies the accuracy and quality of a company’s earnings and cash flows.
- QOE reports are commonly used in M&A transactions, either by buyers to validate the target’s financials or by sellers to prepare for a sale.
- QOE reports are typically paid for by the buyer or financial sponsor, but sellers may also obtain one preemptively.
- QOE reports are not regulated, but should be conducted by reputable providers with industry expertise, financial analysis skills, and the right tools.
- Transparency and preparedness are key for sellers undergoing a QOE, as it allows the provider to efficiently complete the analysis.
- QOE is a component of the broader financial due diligence process, which also includes reviewing the company’s systems, processes, and other financial metrics.
- Having a credible, independent QOE report can help sellers prepare for and accelerate the sale process.
- For buyers, a QOE report provides confidence in the target’s financials and can uncover potential issues or risks.
- Revenue Rocket can provide QOE services to both buyers and sellers, but must maintain independence if involved in the transaction.
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EPISODE TRANSCRIPT
Mike Harvath 00:07
Hello and welcome to this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters in Bloomington, Minnesota. As you may know, if you tune in to our podcast on a regular basis, revenue rocket is the world’s premier growth strategy and M&A advisor to tech enabled services companies. I have my partners, Matt Lockhart and Ryan Barnett with me. Welcome guys.
Matt Lockhart 00:30
Thank you. Thank you. Mike, great to be here. I know we got a cool topic today, getting into some details, and we’re rolling into the holiday season and fired up because we’re I think we’re going to be able to get a couple of deals closed here before the end of the year, and a little holiday cheer and getting ready to kick off a new year. So it’s exciting. What’s going on? Ryan, yeah, well,
Ryan Barnett 00:59
we’ve got a good topic here today, as we focus on IT services firms and M and A and growth strategies for IT services firms, we discuss the topics that we see in a week, and one of the things that we’re coming across this week is quality of earnings reports. And we’re going to walk through what a Q of E means to view, you’ll have to hear quality of earnings turn into Q, Q, o, e, and this is a this is a process that many firms go through, either selling a firm, there’s an option for a Q v, or even when you’re buying a firm, it’s really important to understand the financials of that firm. So we’re going to dig into a q v, what it means for firms and what matters. So Mike, why don’t you get started? What is the quality of earnings report and and why does it matter to IT services companies in the context of M and A transactions?
Mike Harvath 01:52
Yeah, thanks, Ryan and and great to you know. Discuss this topic today. Quality of earnings report is exactly what it title implies. It weighs in on the quality of the earnings of the business. I mean, as you can imagine, if you’re acquiring a business, an IT services company, you need to know that the financial reports as presented are factual. You need to be able to count on the fact that the forecasted revenue and profitability has a reasonable likelihood to occur, and that the data from history is accurate, and that’s exactly what a quality of earnings report does. You can think of it like an audit or a mini audit of the financials to find out and determine what the relative quality of the earnings are pursuant to your acquiring that business. And certainly, you know, you can find small anomalies in those or major anomalies, depending on you know, how that company that is selling has operated, and there’s merit to do it. I think, in every transaction, regardless of size, because you have to have confidence in the numbers if you’re the acquirer, and you certainly have to have confidence in your numbers as presented if you’re the seller. I
Ryan Barnett 03:13
think that’s a good, good start. Matt, where do we typically see Q of E reports used in our in our process. When have you run across them and and how have clients been impacted by either getting one of these or having one done to them?
Matt Lockhart 03:32
Yeah, I mean, so there’s a sort of a variety of instances, and we’ve sort of been on all sides, you know, we’ve supported providing quality of earnings reports independently. When somebody is is looking to go to market and they’re looking for an independent, objective quality of earnings report as part of their package, oftentimes, we are in our sell side engagements. We the buyer, and most often, when there is a private equity or other financial investor in play there, most often there will be requirement post loi in the due diligence process for a quality of earnings, you know, report to be provided. And then, you know, our role is to act as the intermediary to that group that is doing the quality of earnings report and providing all of the applicable information, making it easier on, easy on our comply our clients to provide all the necessary information, and then, therefore commentary and answering questions and and the like. And then for our buy side clients, depending upon, you know, the state of the state with the business to Mike point, most often, it’s a great. Will to have, then we will be providing the quality of earnings report for our buy side clients. So it, you know, happens in a variety of paths.
Ryan Barnett 05:11
Yeah, it really helps frame that up. So if I’m understanding this right, this is a detailed financial look into the company. It’s more looking at things like an adjusted EBITDA analysis, really understanding what goes into EBITDA, or the adjustments that go with that, or the identification, really is some of the expenses that go with that. That report is going to have things like in a revenue analysis by a customer, by a service line, or identifying if there’s recurring or non recurring services. Typically, these reports are going to dig into things like cogs and really, truly understanding the cost of goods sold and the operational operational expense. And there’s typically a section around working capital and profitability by customer, essentially a number of things that are used to gage the financial health of a company, all the way from an invoice being issued to cash being received in the bank, so that those working checks to make sure that all of the functions of the business are doing what they truly say that they’re doing. If I’m hearing this right and understanding this right, it’s also done by a third party provider, Mike. When you’re dealing with companies like this and you’re looking for firms that can provide a quality of earnings report that has the appropriate level of detail. What kind of firms provide these kind of reports, and what are a few things that purchasers of the services should be looking for when evaluating a vendor who provides Q of E reports?
Mike Harvath 06:52
Yeah, good question. Ryan, so quality of earnings reports are provided by a variety of different types of companies, M&A advisors such as revenue rocket provide standalone Q of E reports. You know, I’d like to think we do a pretty good job at it, because we do a lot of them, and we have the right tools and the right staff. I think it’s important to evaluate the level of staff experience amongst the financial team that’s doing a qv report, as well, as you know, are they using sort of industry standard approaches and tools? Now you can go get a Q of E report from everyone, from an in the independent individual, sort of that has a financial experience, broadly, all the way to a large accounting firm, right, and sort of everywhere in between. Now I’m a little biased that I think the better approach is to go to a mid sized firm and one that can provide that work and understands the industry. There’s nuance in our industry, in IT services, and I think that’s lost oftentimes on folks that have not done these types of projects, or they’ve been decentralized into a large accounting firm before, and what that means for you as a customer is that it adds cost and time to that analysis, neither, which I think are a very good thing when you evaluate trying to get a qv done, a report done completely and quickly and most importantly, cost effectively. You know, the prices on Q of E reports range wildly from an individual who you know may have some accounting experience trying to do the do that work. You know, prices there tend to be on the low end, kind of in the 30 to 40k range, all the way up. You know, we’ve seen, we’ve seen quotes as high as into the hundreds of 1000s of dollars, which you know is would be appropriate for a large corporations, Q of E, but not for a firm, you know, like we typically see in the sort of one to ten million in EBITDA, you know, we typically see fees that are in the kind of 50, $60,000 range, or a fair, sometimes as high as 75 depending on the complexity of the firm that is selling kind of in that one to 10 million in EBITDA, usually the best firms to deploy that are folks that are knowledgeable in the IT services space, and, you know, have a good team of analysts that can get the work done with the right tools. It does require different types of skills to do a Q of E. It’s very challenging to do a full Q of E with one individual, because it requires different types of audit skills, if you will. And that’s why a team approach is best.
Ryan Barnett 09:51
And then just a quick follow up question on that Mike, who wins? Who typically pays for a community? Is this a buyer or seller? I’m sure it’s a, probably an It depends. Question, but is there a typical person who foots the bill?
Mike Harvath 10:06
Yeah, I would say typically, a buyer or a financial sponsor of a buyer is who pays for a Q of E, and often times they have the most to lose, so to speak. You know, if you’re looking at acquiring firm, you certainly want to make sure the firm you’re acquiring. Financials are as reported. Now, with that said, there’s plenty of sellers that actually go out and get Q of Es preemptively as they’re going to bring their company to market, and they do that for a variety of reasons. They do that one to make sure that their books are clean and that they tie out and that they’re using, you know, confirming that they’re using good quality accounting practices, that there’s no issue with their chart of accounts or their revenue recognition policies, as an example, and they want that third party validation and confirmation before they would Go to market to sell or recapitalize their firm. Likewise, that if they do that and under if you’re as a seller, you undertake that expense, you can actually dramatically speed up the acquisition process, you know, to get a Q of E completely done cradle to grave is, you know, anywhere from a 30 to 60 day process, typically, and that’s usually done in the due diligence phase of M&A engagement funded, as I said before, by the buyer or the financial sponsor. Certainly you can save all that time if you’ve done a quality of learnings report, an independent qv report has been produced about your firm if you’re going to go to market, and then that’s provided to a potential buyer at the time, once you’re under letter of intent, they oftentimes will take that report for what it is, especially if it was done reasonably recently. You can save that time. I would just add the caveat that that’s not always the case. There are certainly buyers that will always require their own and independent quality of earnings report regardless of what you’ve done as a seller, sometimes it can create a, you know, duplication of effort. It might feel that way, but my experience has been that even as a seller, when you do a Q of E report and a buyer wants to do their own, it can dramatically accelerate the process for them, because the new Q of E provider can certainly review the report that you ordered and get you know, it’ll point to areas that they might need to focus on and limit, and allow them to check box items that certainly Are are clear in the report, as provided by you as a seller.
Ryan Barnett 12:44
No makes sense, and that that third party analysis helps, understanding that if you have a report as a seller that’s going to help, could help accelerate if buyers really trust the sources that it’s coming from. So it’s from, I’m curious, it’s important to pick someone who’s reputable in the market, who has experience in the market, you’re that you’re working with, that has the functional capabilities to do the analysis and the the capabilities and and education and and history to do so I’m I’m assuming that a lot of the people doing this type of work tend to have audits related financial expertise, or a bit of FP and a financial planning analysis. That seems like a bit of a mix, but making sure that there’s just the right education there is that, is there a regulatory component to this mic, like if you mentioned a large accounting firm, from what I understand that the Q of E report has is not necessarily a report that’s mandated or that is, it’s an optional report and it’s not regulated. Is that? Is that the case?
Mike Harvath 14:00
Yeah, it’s absolutely the case. You know, the QV report, the best way to think of it is that it’s a very detailed due diligence report on the financials of the business. And to some extent, all buyers do some level of quality of earnings. It may not, even if they don’t use an outside provider. If you think about what due diligence, financial due diligence is, it is really testing the quality of those earnings. The big question, though, is, is that an independent type report, one that’s done per the industry best practice by professionals that do this for a living and using industry standard approaches and tools, right? That that is a big difference in the, if you will, the quality of the quality of earnings report and the level of detail for which people go. There is an industry standard. But. Practice that should be followed if you’re going to, you know, sign off on a quality of earnings report like we do, as a firm or an accounting firm may do, or, you know, even an independent analyst might do. You know, they have to sign off on that report that they’re, you know, they believe that it’s accurate to their best of their ability, and so, you know, having confidence in the reputation and, you know, skill and approach of the firm that’s doing the report in the end, is pretty important,
Ryan Barnett 15:39
okay, but, but what I’m hearing from you, there’s not necessarily a quote, unquote, certified qv report. There’s no governing body. There’s no regulations. It helps to understand things like gap but the actual report itself. Buyers of report should not expect a certified report or some something from a third party body that’s evaluating the structure of a quality of earnings, is exactly what I’m trying to say. Okay,
Mike Harvath 16:07
yep, that’s correct.
Ryan Barnett 16:11
And Matt, did I turn it the tables a little bit here again, you’ve been working alongside clients that have been through these is there some advice that you can give to customers that are are going through a quality of earnings report, and perhaps any landmines to avoid or or things to to address right away in when going through a third party provider and working with someone as they dig into your financials.
Matt Lockhart 16:40
Yeah, sure. I mean, I think that the, and, you know, Mike referenced this previously, is, is, you know, are we following gap standards, right? Generally Accepted gap standards, and oftentimes in, in the middle market, you know, IT services space, there could be, well on words, there could be gaps in a firm’s practices related to fully accepted gap standards. So what we will do is work with those clients, and you know, understand if there are any accounting methods that are not in line with gap, potentially go back and or create a pro forma that demonstrates how it equates to gap and, or just be prepared for the explanation and and be right up front with, you know, what is in line and what may may not be in line. You know, I think that from an advice perspective, transparency and matter of fact, this is always the best practice, right? It is what it is. The numbers don’t lie, right? And, and, and so the more ready and transparent with applicable explanations prepared ahead of time to then allow the q of the provider. Then they’ve got, they’ve got their method, and you know, they’ve got to check all their boxes to be able to do their job and sign off on their report as efficiently as possible, right? So in other cases, for firms that are fully gap compliant, have done audits on a regular basis, right? It’s really just more of the preparation of the materials, understanding them so you’re able to field questions and then moving the process along as quickly as possible. And I think that’s another point where having the industry expertise is absolutely critical, right, especially in those scenarios where it may not be fully gap accounting based in being able to understand the business so that you can explain, adequately, explain, and ease any concerns for for a qv provider, that’s absolutely critical. I
Ryan Barnett 19:22
Yeah, absolutely. And this is going to feel, and this is a nuanced question, and Mike, I’ll kind of one of the last questions I have for you here. But when you think about this approach, and you’re going through a quality of earnings, how does it differ from due diligence? It feels like the quality of earnings report is really focused more on the financial workings, where due diligence might be more of the operational and other part. But I mean, are these two words synonymous and they’re relatively the same thing, or is there a distinction here that buyers and sellers should really be aware of? Well,
Mike Harvath 19:59
I think. When you think about due diligence, due diligence encompasses more than a typical quality of earnings report would or quality of earnings effort would encompass. So when you think about doing diligence, you do diligence around three major pillars. You’ve heard us talk about this, that deals need to line up strategically, culturally and financially, due diligence and reciprocal. Due Diligence needs to support all three pillars. It needs to support. You know, are we really in strategic alignment? Do we have strategy context to do this deal? Can we get to a place together that we can’t get apart, and then you have to do the requisite diligence to support those assumptions and discussions. Likewise, cultural alignment, you know, we we do a culture grading system here at Revenue Rocket, when we’re helping a client, facilitate a deal, whether that be on the sell side or the buy side, to make sure that we have an objective. If you do diligence, if you will other respective cultures, to identify any potential gaps right up front. We think that’s really important. And certainly that would be part of diligence. And then, of course, all the financial diligence, and if you think of the quality of earnings, it’s really certifying the cash flows of the business as being accurate, and that the numbers that are in the statements are accurate. But there’s other financial due diligence that may need to be done in order to, you know, talk about or review, you know, things as simple as you know, what kind of business system are you using to do, to manage your financial systems in the business? You know is that QuickBooks? Is it? NetSuite? Is it, you know, Microsoft? What is it, right? You know, that’s a diligence effort. That’s not really included in the Q of E, but it is important to know, right? So there’s other diligence questions. Diligence, in many ways, is much broader than what would be encompassed in financial due diligence. Financial due diligence is much more akin to a financial audit pursuant to certifying the cash flows,
Matt Lockhart 22:17
but the financial diligence also then supports the overall diligence, right? So it’s, it’s an important piece, right? And I was thinking about that as you were talking Mike, right? So, so, for example, right, in the financial due diligence and the quality of earnings work, there could be an identification that gross margin has been, you know, under pressure, and first off, from a quality of earnings perspective, making sure that somebody is tracking gross margin appropriately can be a good indicator. But then you know, that may be one of those key performance indicators that a buyer uses to go in and understand the other aspects of due diligence, their go to market methods, their pricing method, their hiring method, etc, etc. So while independent and focused right, it it certainly supports and provides appropriate information for you know, the more comprehensive overall due diligence, operational as well as cultural and leadership due diligence,
Mike Harvath 23:35
Absolutely,
Ryan Barnett 23:37
yeah, absolutely does. If I’m hearing this right, guys, if you’re someone who’s done a quality of ordinance report, they really have to have a credible provider that goes with them, and that provider has to have experience and expertise, especially with the industry that they’re dealing with. So if you’re in our audience, in the IT services world, make sure that you have dealt with someone that’s asking the questions and asking, digging into the right areas for IT services companies, things like MRR come to mind, or be a type of service line, understanding things between like hardware and software, and being able to have a distinction of why those matters. So I think that’s that’s huge. They have to be an independent body. So if you’re working with a company, the company itself, seller, for example, will be producing its own quality of earnings report. But instead, look for someone who is in the industry from a third party perspective, who is has validated from a third party perspective, so that objectivity and dependence starts to become important. The technical competence, being able to have accounting knowledge, to have tax insight, to have data analysis skills, is important, and ultimately, getting reports that are aligned to what you expect, and a collaborative process starts to become. Them important. So you also need a vendor that’s going to be on time and uses tools and technology. For example, we’ve got technology in our stack that helps us really ingest financials in a in a comprehensive way, and it’s important for vendors to be efficient and effective in how they go to market. So have it making sure that they are prepared for what they do, and then ultimately, what you’re getting there’s these are expensive reports, and getting the value out of that to make sure that as the salary you’re prepared for an exit or for a buyer, you’re really, truly understanding the risk and reward of the of the acquisition is critical. Quick summary. What I heard, again, report is really a deep dive analysis into the financials of the company. I heard industry expertise. I heard that’s critical. I heard that it’s important for this to get done. It will get done and somehow surviving it. Having a credible advisor along your way to help you through that is also helpful. Matt, Mike, anything else you wantnto add to that summary?
Matt Lockhart 26:15
You know, yeah, all I was going to add, Mike is, is that it’s it’s worth talking about the win and the why and and the value of potentially if you go into market. And part of the way of of reducing uncertainty is to have a report prepared, but talk to your advisor first as to the validity of that. And then you know, if you’re working by side and and based upon the mandates that you have, what is the level of requirements for a quality of earnings report? Sometimes say, a managed services business that is very, very stable, you can accelerate that report and, you know, save, save yourself some money. So I think it’s worth talking about and strategizing to get the most effect and the most value out of the process.
Mike Harvath 27:13
Yeah, I would, I would add also that pure seller that’s contemplating doing the Q of E report. You know it is a one time charge, just like hiring an M&A advisor, and those are add backable to your EBITDA. We don’t talk about this enough, but you know, when you typically think about investing in working with an advisor or and taking on deal specific costs, those don’t negatively impact your value in the sense that their add back their qualified add backs to EBITDA, and they’re considered one time expenses in the eyes and minds of a buyer, and thus, from a valuation perspective, since your valuation is indexed on earnings and EBITDA, they don’t impact you negatively. Think that’s important to understand, if anything, it’s going to be a positive move for you to be positioned to move more quickly if you’re going to run a process. And certainly, as you’ve heard of say many times, we strongly encourage everyone in the audience to hire a competent advisor to help them get a deal done, whether that’s on the buy side or the sell side. These are hard deals to get done. Some call them the most unnatural act in business, and you need a well versed advisor to help you along the way. So with that, I think we’ll tie a ribbon on it for this week’s suit the moon podcast. Encourage you to tune in next week when we unpack further topics of interest around growing your business organically or through acquisition or positioning your business for an exit or a recap. Thanks again, and take care.