Diversification is a tried and true way to balance risk. For investors looking to buy your business, that means looking at your financial health from many angles.
Selling a company, subsidiary, or division may be one of the most significant events in your career. The stakes are extremely high because while a successful deal is likely to yield great financial rewards, a bad deal can have devastating repercussions that last for years. Even the most experienced business owners may find themselves unprepared for the challenges that arise.
One way to diminish surprises is to understand how your counterparts across the table may gauge the financial health of your business, and to understand how that aligns or differs from your own measurement.
In the context of mergers and acquisitions, potential buyers may get some level of assurance when the seller has the company’s financial statements audited or reviewed. However, buyers typically do not — and should not — rely solely on audited or reviewed financial statements when making an investment decision. The purpose of an audit or review is to provide assurance that management has presented a company’s financial performance and position fairly — not to identify issues likely to be of interest to a buyer.
The sell-side quality of earnings report
A sell-side quality of earnings report is focused on providing potential buyers with a deeper understanding of the business. This includes:
- Sustainable economic earnings
- Historical revenue and expense trends
- Historical working capital needs
- Key assumptions used in management’s forecast
- Tax, information technology, human resources, and risk management matters, as appropriate
Although audits or reviews may provide a starting point for a potential buyer’s evaluation of your company, such reports generally do not comment on the focus areas noted above.
Quality of earnings
For obvious reasons, buyers are particularly concerned with fair valuation. Because businesses are often valued based on a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization), a sell-side quality of earnings report will focus on the “quality” or sustainability of the company’s earnings. Unusual or nonrecurring income and expense items, over or under-stated assets and liabilities, post-closing cost structure changes, and the consistent or inconsistent application of accounting principles are all analyzed to adjust historical EBITDA to reflect sustainable earnings.
Audit or review procedures may include analytics to understand trends and relationships over the historical period, but the reports do not comment on the market drivers behind those trends. Sell-side quality of earnings reports address key market drivers, sales strategies, customer relationships, and customer churn, while also attempting to understand whether the trends reflected in the financials are sustainable.
Buyers and sellers typically negotiate a “target” working capital to be delivered at transaction close. The negotiated amount is usually based on the average working capital balances over the previous 12 months, but should also consider:
- Recent growth trends
- Industry conditions
- The seasonality of the business
- The specific composition of working capital accounts
Without this insight into monthly working capital accounts, the seller may be at a significant disadvantage when negotiating the working capital target.
Perhaps most importantly, the sell-side quality of earnings report may provide important qualitative observations arising from discussions with management. These observations may include key findings regarding the company’s internal control structure, management and accounting team, and accounting information systems. Qualitative observations rarely appear in financial statements, but may be just as important in helping a buyer make an investment decision.
Provide a comprehensive picture of the potential value of your business
An audit or review provides assurance that management has presented a fair view of a company’s financial performance and position in accordance with well-defined rules and procedures. However, a sell-side quality of earnings report gives the buyer a more comprehensive understanding of the potential value of your business. Enlisting a professional to help conduct a thorough sell-side quality of earnings engagement early in the process can reduce the likelihood of critical issues arising later and ultimately help to preserve value and contribute to a successful deal.