Drive Deal Confidence
Last year, the landscape of due diligence in potential transactions saw a notable shift towards increased scrutiny and detail from buyers. This trend and a decrease in buyers’ risk tolerance underscore advisors’ need to prepare clients meticulously for due diligence processes. As the adage goes, “Time kills all deals.” In today’s environment, time also breeds more buyer diligence requests, emphasizing the urgent need for thorough preparation.
Proactively identifying issues before engaging with buyers is paramount, allowing seller organizations the opportunity to rectify issues or manage expectations effectively. It is like getting a home inspection before putting your home on the market so you know what a buyer’s inspector will find and try to use as negotiating leverage. When buyers uncover issues, it often transpires at a stage where the seller has diminished negotiating leverage, amplifying the importance of comprehensive diligence across various aspects, including human resources, environmental, commercial, and financial.
For closely held companies with limited financial reporting required to those outside their organizations (i.e., banks, investors, etc.), a third-party validation becomes crucial when considering a transaction, especially when financial results are reported on a cash basis or modified accrual methodology. Compliance with US GAAP standards, including accrual-based accounting, ensures consistency and meets the reporting requirements of lenders, investors, other stakeholders, and potential buyers.
Over recent years, a common tool for preparing clients for due diligence and mitigating surprises has been the quality of earnings (QoE) analysis undertaken by sellers before market entry. Carried out by an independent accounting firm, this analysis provides a third-party assessment of the company’s financial conformance to US GAAP Standards, aligning with buyers’ expectations and facilitating smoother negotiations.
Quality of Earnings (QoE) Explained
The QoE analysis delves into the intricacies of accrual-based financial reporting, ensuring that the reported earnings are of high quality and accurately reflect the company’s financial performance. Adhering to US GAAP Standards, it scrutinizes the consistency and reliability of earnings over time, identifies any irregularities or anomalies in the financial data, and assesses the underlying factors driving the earnings figures. It also prepares a standard and consistent measure of working capital over time. By conducting a thorough QoE analysis, sellers can proactively address any potential concerns or discrepancies in their financial statements, thereby enhancing transparency and credibility in the eyes of potential buyers.
Historically, buyers performed this analysis during their due diligence to validate and confirm the financial results of acquisition candidates.
US GAAP Explained
US GAAP stands for Generally Accepted Accounting Principles and refers to the standard framework of accounting principles, standards, and procedures U.S. companies use to prepare and present their financial statements. US GAAP provides a standard set of rules and guidelines that ensure consistency, comparability, and transparency in financial reporting, making it easier for investors, creditors, and other stakeholders to understand and evaluate a company’s financial performance.
Investing in a quality of earnings analysis offers several advantages in the due diligence process.
Demonstrates seller seriousness to potential buyers: It is crucial to offer reassurance to potential buyers during the bidding process. In a competitive environment with numerous sellers and varying deal qualities, buyers prioritize deals they believe can be successfully completed. A QoE analysis provides assurance that the financial figures forming the basis of valuation are reasonable and less likely to undergo significant changes during due diligence.
This assurance empowers sellers’ advisors to leverage it as a negotiating point during the buyer’s due diligence process. By proactively conducting a QoE analysis upfront, much of the necessary data is already prepared for the buyers’ QoE examination. With this information collected and verified in advance by an independent accounting firm, investment bankers can urge buyers to limit the scope of their QoE assessment, rely on the work conducted by the sellers’ QoE provider, and expedite the buyer’s review process.
Even during the QoE process itself, having a robust QoE provider representing the seller enables quicker and more direct responses to queries from the buyer’s consultants. This streamlines the communication process and reduces the need for extensive rounds of discussions and data retrieval by the company’s CFO in response to the buyer’s inquiries.
Provides a counterpoint of view during negotiations: A buyer might leverage the findings of a QoE analysis to pinpoint and negotiate areas where the interpretation of certain accounting procedures is subjective or uncertain. With our own QoE, our client benefits from having both an investment banker and an accounting professional who can present contrasting viewpoints. This added advocacy serves as a valuable asset for the client company, ensuring that both perspectives of the argument are adequately represented. Additionally, in many instances, with a sell-side QoE, we can strategically raise issues upfront in our analysis to the seller’s advantage.
Facilitates the identification and validation of financial adjustments: As part of a comprehensive sell-side process, an investment banker collaborates with management and shareholders to identify add-backs, one-time expenses, pro-forma adjustments, and other modifications to the financial results. Presenting these adjustments and supporting documentation or analysis allows for an initial assessment of their strength. A reputable QoE provider evaluates each proposed adjustment to ensure its credibility, standard of reporting, and acceptability. Including adjustments that do not meet these standards can undermine a seller’s credibility. The primary goal of the QoE is to establish and enhance credibility.
Basis for Positioning Working Capital: The impact of net working capital is often an afterthought in a transaction, even though the impact of assessing working capital can be significant. By completing the analysis in advance, sellers can determine the best positioning for working capital and present this to buyers while deal competition remains intense. If not, sellers respond late in the transaction process after a buyer completes their diligence when the seller has less negotiating power.
Increases certainty of closing and on your terms: It is widely understood that the advantage shifts from the seller to the buyer once a letter of intent (LOI) is signed. At this point, the seller commits to exclusivity with the chosen buyer, closing off discussions with other potential suitors. The seller is also expected to provide the buyer with unrestricted access to its financial records for due diligence. These dynamics give the buyer increased leverage, as they ultimately control the deal’s fate.
Engaging an advisor for a sell-side Quality of Earnings (QoE) analysis allows the seller to maintain maximum control and present themselves in the best possible light. Together with the efforts of the seller’s deal advisors, the QoE report becomes a valuable tool to complement and bolster marketing materials shared with potential buyers. The outcome is a seller who is better prepared to withstand buyer due diligence and a buyer who is more confident in proceeding with the transaction.
A third-party assessment lends authenticity and support to add-back adjustments when they are presented to buyers and their advisors.
The sole purpose of a quality of earnings analysis is to build credibility, enhance transparency in financial reporting, and allow the seller to optimize its positioning. Investing in a QoE analysis prepares sellers for due diligence, enhances the deal’s authenticity, facilitates negotiations, and strengthens the overall transaction process. It serves as a critical tool in navigating the complexities of today’s transaction environment, helping reduce back and forth with the buyer and ultimately contributing to deal success.