Quality of Earnings Analysis for M&A Success

Understanding Quality of Earnings (QofE) for Startup Founders

For startup founders, a firm grasp of the quality of earnings (QofE) process is crucial for maximizing company value in several key situations.

When is a QofE Necessary?

There are three primary scenarios where understanding QofE is essential. These include preparing for a Series A funding round and any subsequent venture capital investments.

Furthermore, a QofE is vital when pursuing a strategic acquisition of your company. Finally, it’s a critical step when you ultimately decide to sell your business.

A Framework for QofE Preparation

This article provides a structured approach to thinking about and organizing your QofE. It will also highlight the most frequently examined areas during mergers & acquisitions (M&A) and private equity transactions.

Being prepared will streamline the process and ensure you are well-positioned to demonstrate the true financial health of your startup.

Key Considerations for QofE

• Focus on maintaining a clear and organized financial record.
• Anticipate the types of scrutiny that will be applied during due diligence.
• Understand the common items that investors and acquirers will prioritize.

Proactive preparation in these areas will significantly benefit you throughout any M&A or private equity engagement.

The Importance of a Quality of Earnings (QofE) Assessment

A Quality of Earnings (QofE) assessment is undertaken to refine reported EBITDA figures. The aim is to arrive at a restated EBITDA that accurately portrays the company’s ongoing financial performance.

Furthermore, a QofE provides a historically consistent adjusted EBITDA, enabling comparisons over a period of two to three years.

How QofE Impacts Company Valuation

The impact of a QofE on a company’s valuation can be substantial, primarily for three key reasons:

• The adjusted EBITDA serves as the foundational metric for valuation when a buyer or investor utilizes an EBITDA multiple.
• Recalculation of the effective growth rate is performed using the adjusted revenue figures.
• Future forecasts are built upon the adjusted revenue and EBITDA as a starting point.

Therefore, it’s crucial for all business owners to grasp the principles of determining appropriate adjusted EBITDA and revenue for their company.

Often, founders involved in M&A transactions lack familiarity with QofE processes, potentially leading to undervalued offers.

This guide is designed to prevent that scenario. It will equip you to negotiate your company’s valuation with confidence and on a level playing field with investors.

Whether you are selling or buying, understanding the QofE process is invaluable. Sellers gain insight into the buyer’s perspective, while buyers can improve their acquisition valuation skills.

Understanding the Professional Quality of Earnings (QofE) Assessment

A professionally executed quality of earnings (QofE) assessment is achieved through a detailed examination of documentation typically found within a data room. This encompasses a wide range of materials, including legal documents, financial statements – such as profit and loss statements, balance sheets, and cash flow statements – alongside audit reports, management presentations, and contractual agreements.

A central tenet of QofE analysis involves continually questioning whether presented information necessitates an adjustment to key financial metrics. These metrics include revenue, EBITDA, net working capital (NWC), and net debt.

The inclusion of NWC and net debt is deliberate, as they frequently exert an indirect influence on adjusted EBITDA. For example, a reduction in historical inventory levels could lead to decreased storage expenses. Consequently, adjusting historical inventory should also prompt a corresponding adjustment to adjusted EBITDA.

Beyond document review, a robust QofE analysis depends significantly on interviews with company management. Regardless of the time spent analyzing financial data, the ability to corroborate information and understand underlying trends through management insights is crucial for accurate conclusions.

Without management confirmation and explanation, a complete and reliable understanding of the financial figures cannot be attained.

Guiding Principles for Effective QofE Construction

Establishing a consistent and efficient approach to building your Quality of Earnings (QofE) analysis is crucial. A key element involves automatically associating all information encountered – both read and heard – with potential adjustments to the QofE.

This connection should become an instinctive part of the engagement process. Consider every piece of data as a potential driver for refinement.

Holistic Financial Statement Impact

When identifying an event or item requiring an adjustment, always evaluate its comprehensive effect on the financial statements. For example, if revenue is affected, determine if corresponding cost implications exist.

A thorough assessment ensures a complete understanding of the financial repercussions.

Avoiding Double Counting

It’s essential to verify that the cost being adjusted hasn't already been neutralized by a separate accounting entry. Confirm the adjustment genuinely impacts EBITDA.

Preventing double-counting maintains the accuracy and integrity of the QofE.

EBITDA Classification

Ensure the cost subject to adjustment was initially categorized above the EBITDA line. Adjustments should only be made to items appropriately positioned within the income statement.

This maintains consistency with standard financial reporting practices.

Objective Quantification

Strive to quantify each adjustment using the most impartial and logical methodology available. While precise figures aren't always attainable, aim to establish a reasonable range where necessary.

Transparency and objectivity are paramount in QofE analysis.

Contextual Company-Wide Review

Always place each adjustment within the broader context of the entire company. Evaluate whether categorizing an item as “non-recurring” or “non-normalized” is justifiable given the overall business operations.

Consider if the item should realistically be viewed as part of the standard course of business.

Correct Periodization

Confirm that the adjustment is applied to the correct financial reporting period. Accurate timing is vital for a reliable QofE assessment.

Proper periodization ensures the financial statements accurately reflect the company’s performance.

Structuring a Quality of Earnings (QofE) Analysis

To effectively organize your analysis, adopting a framework similar to that utilized by major accounting firms – such as PwC – is highly recommended. Presenting your findings in this manner will resonate with professionals experienced in mergers and acquisitions (M&A) transactions.

• Examination of management-prepared adjustments (specifically for buyers).
• Review and reclassification of financial items.
• Implementation of normalization procedures.
• Application of pro-forma or standalone adjustments.
• Consideration of additional relevant factors.

A well-structured presentation, following this template, will enhance clarity and understanding.

The reversal of management adjustments is pertinent only when the target company’s management has already presented adjusted EBITDA figures. In such instances, a detailed review of each individual adjustment is necessary, either validating its appropriateness or reversing it if discrepancies are found.

Reclassification typically represents the most straightforward adjustment type. It involves correcting the placement of items that were incorrectly categorized within the income statement, specifically concerning their inclusion or exclusion from EBITDA calculations. A review of the trial balance will often reveal instances where items below the EBITDA line have been improperly included above it, or vice versa. For example, interest income may be incorrectly reported as part of revenue.

Normalization encompasses a variety of adjustments designed to determine an EBITDA figure that reflects a sustainable level of earnings, effectively removing the impact of unusual or non-recurring events.

Pro-forma/standalone adjustments are employed to account for recent business changes and their projected full-year impact. This includes removing the effects of discontinued operations or, conversely, incorporating the anticipated contribution from newly acquired businesses. In carve-out transactions, assessing the additional costs associated with operating as an independent entity is also crucial.

Other matters serves as a catch-all category for items that may influence valuation or the decision to proceed with a deal, but which are difficult to quantify precisely or whose inclusion in the adjusted EBITDA calculation might be considered overly aggressive.

Detailed Examination of Normalization Adjustments

These adjustments can arise from a diverse range of circumstances, requiring careful consideration.

Accounting adjustments may be necessary to ensure consistency in EBITDA presentation across different periods, particularly if accounting policies have changed. Furthermore, discrepancies between the company’s accounting practices and prevailing market standards – such as lease accounting – may necessitate adjustments. Simple accounting errors overlooked during the audit process can also require correction.

One-off items represent events that have impacted EBITDA but are unlikely to recur in the future. A company-wide celebration, for example, might generate expenses that are not representative of ongoing operations.

Cut-off procedures are essential to ensure that revenues and expenses are recognized in the correct accounting period. Particular attention should be paid to provisions and reversals of previously established provisions.

Other costs may relate to expenses incurred by the owners or founders that are not reflective of the business’s future operating costs. Personal expenses charged to the company, for instance, should be excluded.

Specific non-cash items, such as stock-based compensation, also warrant consideration during the normalization process.

Ultimately, this framework serves as a guide for structuring your analysis. In practical scenarios, some adjustments may fall into multiple categories; however, as long as the adjustment itself is accurately identified and calculated, minor classification differences are unlikely to be critical.

Most common QofE adjustments

To facilitate your financial analysis, let's examine frequently encountered QofE (Quality of Earnings) adjustments observed during due diligence processes. This serves as a helpful checklist during M&A or fundraising activities.

1. Reclassification

Hidden costs – interest and depreciation: During financial due diligence at PwC, I frequently encountered instances where interest expenses and depreciation/amortization were obscured within other cost categories. This can manifest as interest costs reported within a general “other cost” line, inflating figures above EBITDA. Alternatively, management accounts may be structured by destination rather than by nature.

For example, a P&L might include a “vehicle costs” line, which, upon closer inspection, contains car depreciation – an expense that should properly be positioned below EBITDA.

2. Normalizations

Transaction-related expenses: These encompass all costs linked to the current transaction, such as legal fees, due diligence costs, and supplemental accounting expenses. Adjustments may also be necessary for prior M&A deals.

Consulting fees: Companies often engage consultants for one-time projects like restructuring, strategy development, or software implementation. Restating these costs from EBITDA is acceptable if their non-recurring nature is demonstrably proven.

However, avoid conflating these one-off consulting fees with the costs of temporary contractors hired to address staffing shortages, as these represent ongoing operational expenses.

Exceptional events: Consider a company-wide trip to Las Vegas to commemorate a significant anniversary. If verifiable as a unique, one-time event – not the standard annual retreat – an adjustment may be warranted. However, carefully assess the adjustment amount.

Did the Vegas trip supplant the usual weekend retreat to Vermont, which typically costs several thousand dollars annually? If so, adjust only for the excess cost beyond the historical average.

Severance payments: Unusual severance packages, inconsistent with historical trends, can be adjusted in the QofE. Always investigate potential related litigation from former employees.

Damage from disasters: If a fire severely damaged a Montana factory, causing a three-month closure and revenue loss, how should this be addressed? First, confirm the revenue loss with supporting documentation, and account for any sales rebound upon reopening.

Second, the adjustment should reflect the lost gross profit, not the total lost revenue. Had the sales occurred, the company would have incurred associated COGS. Finally, verify any insurance compensation or government assistance received above EBITDA, and allocate adjustments to the correct periods.

Warranty/inventory provisions: Many industries utilize statistical provisions for warranties or inventory write-offs. This involves estimating potential losses based on historical data. However, these provisions can be subject to manipulation.

Therefore, scrutinize the calculation methodology and identify any policy changes or unusual provision releases impacting EBITDA during the review period.

Revenue and cost allocation: The timing of revenue (and potentially costs) recognition between periods is an accounting decision. Consider a three-month consulting contract with varying resource allocation each month.

Recognizing $10,000 of revenue monthly might be standard, but if 50% of resources are dedicated in the second month, 50% of the revenue should logically be allocated there to align with costs. While management may manipulate this allocation, your QofE process should verify proper alignment, impacting EBITDA and growth rates.

Charitable donations: Donations to charity or local organizations made through the company, particularly common in the U.S. and Australia, can be included in the QofE if they are unlikely to continue post-acquisition.

R&D capitalization: R&D expenses can be capitalized, adding the value of engineers’ salaries to EBITDA when developing products that become intangible assets. This is akin to outsourcing development and capitalizing the expense. Industry and country-specific regulations apply, but review the calculation to ensure only legitimate R&D costs are included.

Bonus structures: Assess bonus structures and identify any exceptional bonuses paid to management. Bonuses tied directly to revenue exceeding budget are less likely to be considered non-recurring.

Rent straight-lining: Rent arrangements vary, including periods of free rent or scheduled increases. To ensure fair treatment, calculate the total rent cost over the lease term and divide it by the number of years. The difference between this adjusted rent and the reported rent is your adjustment.

Early payment discounts: Offering discounts for early invoice payment can be viewed as a financing item, representing the cost of financing working capital. Adjusting for these discounts from EBITDA may be appropriate, alongside net working capital and net debt adjustments.

3. Pro-forma

New/discontinued products: The recent launch of a new product or discontinuation of a flagship product requires assessment. Is this a regular occurrence, or an exceptional event? A pro-forma adjustment can estimate the full-year impact of the change.

For example, if a new product launched in March, you can adjust EBITDA by accounting for launch costs and annualizing the profit generated over the nine months. If sales ramped up, base the adjustment on the last six months of sales.

Acquisition/divestiture impact: Apply the same logic as above to acquisitions and divestitures. Incorporate the full EBITDA of a newly acquired business, and adjust for the impact of divestitures. Adjusting for a full year is generally appropriate.

New executive hires: Consider the full-year impact of a new C-suite executive’s salary. Adjustments are more defensible for positions without direct revenue impact, such as a compliance director hired due to regulatory requirements. Adjusting for a replaced CFO’s salary during an interim period may also be justified.

Concluding Remarks

The preceding list isn't all-inclusive, and numerous other Quality of Earnings (QofE) modifications can substantially influence a company's valuation, particularly when assessed using a higher EBITDA multiple.

Senior leadership should recognize these potential adjustments, as the CEO and CFO are directly involved in company operations and best equipped to identify applicable modifications. Proactive awareness is beneficial for managers, as these issues frequently arise during negotiations.

However, comprehensive financial due diligence is a complex process demanding specialized skills and expertise. Consequently, your current accountant or CPA might not be optimally positioned to provide guidance without prior experience in Mergers & Acquisitions (M&A).

We strongly advise seeking counsel from seasoned financial due diligence specialists.

At a minimum, you are now equipped with the terminology to engage in informed discussions with more experienced parties in a transaction!