“Quality of earnings” is a phrase that is becoming more common in M&A lexicon and is often associated with the due diligence process undertaken before an acquisition. However, as we will explore in this article, business owners should consider the quality of earnings of their companies long before a Letter of Intent has been signed. Not to mention, the potential benefits from incorporating this thinking into their everyday processes will result in a healthier and more attractive company, which may potentially fetch higher valuations than otherwise.
What does Quality of Earnings Mean?
While there are many definitions of quality of earnings, I would define it as the true economics of an operating business, as opposed to simple accounting income, which may be distorted in a number of ways through accounting policies, non-cash or non-operating entries, as well as non-recurring events. Thus, in a firm with a high quality of earnings, we would expect increases in net income will also have corresponding increases in cash flow from operations. Conversely, a company with low quality of earnings might show a positive net income on its income statement, but despite this might have actually generated negative cash flow from operations.
Why Do Buyers Care?
Buyer’s care about quality of earnings for a number of reasons. First, the valuation of the acquisition will likely be based on a multiple of normalized EBITDA. The process of normalizing EBITDA is important because the valuation should be based on the true cash flows of the business, and not impacted by anomalies, inconsistent policies, or non-arms length pricing. The higher the quality of earnings, the more likely a prospective investor will be willing to bid at a higher valuation, offer more favourable terms and conditions, or both. Conversely, a low quality of earnings will serve as a red flag to buyers to either increase the scope of their due diligence, lower the offering price, or perhaps walk away from the deal entirely.
Why Should Sellers Care?
Owners who want to sell their businesses should care about the quality of earnings being generated by their company because it may have a material impact on not only how their company is valued but on the overall attractiveness to prospective buyers. The reality is that companies with high quality of earnings may sell for a premium over companies with lower quality of earnings. Additionally, being transparent with potential buyers is most likely to be viewed positively, even if that means a business has to reveal some of its warts. This is increasingly why Quality of Earnings reports are being produced to help facilitate transactions.
Options for Businesses
If you are an owner of a business, what options do you have to assess and improve the quality of earnings in your company? Below we discuss four options.
1. Hiring a Financial Professional
Hiring a controller or CFO (even on a part-time or fractional basis) to oversee your financial function will go a long way to cleaning up your financials and improving your company’s quality of earnings. The extra advantage of a financial professional is that potential issues can be flagged well ahead of time, long before the sales process has even begun. While the concept of a fractional CFO is relatively new, having emerged over the past decade or so in Canada, prospective resources are available from a number of different places, thus providing today’s business owners with a multitude of options to clean up and improve the quality of their company’s earnings.
2. Exit Planning Stage
Let’s say you are two to five years away from a potential exit and you’ve recently hired an exit planner to help you design a successful transition strategy. An experienced exit planner will take a look at your financials and give you some insights into your company’s quality of earnings along with some recommendations on what steps you can take to make improvements. The primary benefit of getting an early start on improving your quality of earnings is several years of strong results will impress a prospective buyer much more than doing a last-minute clean-up of the financials. Having a track record of at least two years (and ideally more) of high quality of earnings speaks volumes to prospective investors about the attractiveness of the business they are seeking to purchase. As a bonus, it also will help to increase potential valuations through lowering the company’s risk profile.
3. Sell-side Quality of Earnings Report
Increasingly, companies that go on the market are having sell-side Quality of Earnings reports prepared for them as part of the process. The advantages of having a sell-side Quality of Earnings report prepared are numerous and include:
- They can attract prospective buyers as it may lower the perceived risk of the organization to outsiders due to having its financial house in order;
- Prospective buyers like transparency and having a sell-side Quality of Earnings report prepared demonstrates a willingness to buyers that you are open and co-operative;
- The report can serve as an advance warning to sellers about potential issues that may arise during due diligence, thus giving management time to address critical issues in advance.
All of the above can lead to more prospective suitors, smoother due diligence, and potentially higher valuations.
4. Buy-side Quality of Earnings Report
The final alternative available to companies interested in selling is simply waiting for a buy-side Quality of Earnings report to be generated during the due diligence phase. This passive approach, however, is fraught with risk since you have left yourself at the mercy of the prospective acquirer. Due diligence is generally a time where prospective offers are whittled down after the potential acquirer seeks to find every weakness and potential risk to justify downward adjustments to their original offer price in the Letter of Intent. Waiting until a Letter of Intent has been signed to give some thought to quality of earnings, however, is likely going to result in a substantially reduced offer or even a prospective acquirer walking away.
The lesson: this less than ideal situation can be avoided by being pro-active and looking at your quality of earnings ahead of time, ideally through a comprehensive exit planning process three to five years before your anticipated exit. By incorporating this into your planning process, unfavourable surprises and hurdles to a successful exit can be minimized.
- Quality of earnings is an important concept to prospective buyers, and accordingly should also be given a high priority by business owners looking to transition in the next three to five years.
- Business owners should address quality of earnings as part of everyday management of the business, and at a minimum should be addressed during the exit planning stage, years before the anticipated exit.
- A high-quality of earnings attracts more prospective buyers, makes due diligence go smoother, and will likely result in higher valuations.
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