What is Quality of Earnings?

In the process of selling a middle market private company, the buyer will eventually seek to validate the cash flow and financial information presented to them in the marketing materials; the information typically used to value the business.  Once the Letter of Intent (LOI) is signed, the buyer will commence due diligence, which is a confirmatory process for ensuring the data they’ve received regarding the business to-date is accurate and correct, and to more fully understand all aspects of the company.

Traditional due diligence includes scrubbing the financial information to understand the timing and nuances of the business’ revenues, expenses, cash flow, accounting methods and practices. As part of this analysis, buyers will typically undertake a quality of earnings (QofE) analysis or assessment, usually conducted by an outside accounting firm.

Many transactions are structured as a multiple of EBITDA, which is further adjusted for the impact of any nonrecurring or nonbusiness items reported in the historical operating results of the target. Adjusted EBITDA typically serves as the foundation for buyers in building their overall valuation model and this model drives the determination of the ultimate purchase price. When transactions are based on adjusted EBITDA it is critical to assess the true baseline earnings power of the company.

Audited financial statements primarily focus on the balance sheet to ensure that the beginning balances and the ending balances of all the assets and liabilities are materially correct. This is not to imply that there is not scrutiny of the income statement by the target’s auditors, but that is generally at a much higher level than is needed to adequately understand a seller’s business model. In most cases, there can be period-to-period changes in earnings and other fluctuations that are not revealed by an audit and may be of significance to a deal. As mentioned above, business valuations and some transaction financing are predicated on a certain level of available cash flow based on the core earnings of the underlying business. Although a review of audit working papers is often a part of a QofE assessment, it is only used as a starting point for further, more forward-looking analysis.

A QofE assessment is conducted to fully understand the historical revenues, cash flow, and earnings. Although one benefit of such an assessment includes the clarification of any accounting anomalies, a thorough assessment should result in a number of other benefits, including:

  •    Identification of concentrations of risk, including reliance on large customers, sole-source vendors, or key employees
  •    Quantification of the effect of trends in product pricing, volume, and sales mix on the target company’s revenues and gross margins
  •    Analysis of the working capital needs of the business to better understand operating cash flows
  •    Identification of unusual and nonrecurring items of income and expense that need to be removed to assess the underlying cash flows of the target going forward
  •    Comparison of accounting policies used by the seller with those of the acquirer to better understand the effect of the sale or acquisition

The QofE assessment also seeks to validate normalization adjustments and EBITDA add-backs presented by the seller.  A byproduct of the process usually includes highlighting variances or non-conformance to GAAP (generally accepted accounting practices).  As insinuated by its name, the QofE report will provide insight into the quality of revenues and cash flow.  Quality can be measured a number of ways and in terms of the underlying nature of these values – – such as the concentration of revenues, cash flow and accounts receivable from a few customers.  Another underlying characteristic is seasonality… which is variability of revenues and cash flow based on a cycle within the fiscal year.

Even though a QofE assessment focuses on the historical performance of the selling company, its true purpose is to gain insight into the target’s future operating results and cash flows. This is seldom the focus of a traditional audit.  Valuation of privately held companies is almost always based on future cash flow.

While we operate primarily as M&A advisors from Raleigh, North Carolina, in today’s US market, proactive sellers are choosing to preempt the buyer’s QofE work with their own assessment of their financial performance, and make corrections to or restatement of financial information before going to market.  At a minimum, sellers are identifying areas that will likely to be of concern to a buyer, and developing a credible explanation and presentation of their issues so as to eliminate surprises. Many private companies do not have audited financial statements and use either modified cash accounting or a loose version of GAAP … thus creating predictable accounting problems when attempting to present fully GAAP compliant statements.  The most common issues are we encounter with financial statements of technology, B2B service businesses, manufacturers and distributors include:

  •    Incorrect revenue recognition
  •    Expensed CAPEX for tax purposes vs. GAAP depreciation
  •    Lack of accruals for PTO and payroll
  •    Poor or no tracking of customer deposits or deferred revenue


[1] Source: Middle Market M&A: Handbook of Investment Banking and Business Consulting; John Wiley & Sons 2012


Know your EBITDA

If you are considering selling your North Carolina based business, a key metric you must understand is EBITDA – Earnings before Interest, Taxes Depreciation and Amortization. Buyers typically derive their initial value based on a multiple of the company’s EBITDA.

Ultimately, future cash flow determines value; and EBITDA is a proxy for that cash flow. When adjusted for owner related and one-off items, this measurement of the company’s earnings can gives buyers an indicator of what the company may look like in their hands. EBITDA is important to buyers as it enables them to evaluate a company’s level of profitability without giving consideration to the capital structure and factors like tax planning and financing activities. Business owners can increase EBITDA, and provide a truer picture of the company’s earnings, by adjusting for one-time non-recurring expenses such as capital projects that were expensed, professional fees, above market owner compensation, and broader items like non-recurring components of research and development.

The process of deriving an adjusted EBITDA is called normalization and results in a recast income statement (and sometimes a recast balance sheet). There are two steps to this process. The first is adjusting the financial statements to assure compliance to GAAP (General Accepted Accounting Principles) and the second is establishing a list of add-backs. There are nuances and differences between tax accrual accounting and GAAP reporting that can have a significant impact of value, in both directions. Typical areas of concern deal with revenue recognition and year-end accruals. Understanding the adjustments to comply with GAAP usually requires a CPA that has an audit background and understands public accounting reporting.

If you are considering selling your business or pursuing an acquisition, consider partnering with an M&A advisor or investment banker that can work closely with you to prepare the business for sale and optimize the value beforehand. Experienced intermediaries will have recast financial statements and understand what types of add-backs can make a significant defensible impact on EBITDA and conversely know when to avoid adjustments that may actually jeopardize your claims of true cash flow.

Adjustments, or add-backs, have to be defensible for a buyer to accept them and use them to establish a value. In most cases, interested buyers will ask for a copy of the recast worksheet so that they can analyze the add-backs and map them to a final adjusted EBITDA number. If the numbers don’t seem plausible, you, the seller, will lose credibility, which can negatively impact value. That said, the act of recasting or adjusting your EBITDA to represent the most realistic picture of profitability under a new owner should not be a creative exercise.

With a defensible, sound adjusted EBITDA in hand, the question becomes ‘how does the buyer apply the multiple’? One of the primary factors in determining the multiple is the industry or nature of the business. For example: pure distribution companies that don’t add significant value can trade as low as three times adjusted EBITDA depending on the size of the business, whereas value-added distributors can trade much higher. Technology companies fetch much higher multiples and can oftentimes trade on revenue multiples due to the potential for high growth and high profits.

Strategic buyers tend to pay higher multiples of EBITDA because the acquisition has some synergy with their existing business and can be accretive; meaning that it can increase their earning per share. In a similar vein, a private equity group with a platform company seeking to acquire your business as an add-on, the investment is strategic in nature and may command a greater multiple than a standalone financial investment.

To maximize value in a sale transaction and move the multiple to the higher end of the range, it is important to present the true value of the company to a potential buyer – financial or strategic. To do this, explaining the strategic positioning, core capabilities, market differentiation, strength of your team, and growth opportunity of the business in a clear and succinct manner is of utmost importance. The combination of a growing a business, solid financial performance, good business practices and appropriate risk mitigation is likely to garner the optimal value.

So, remember EBITDA – the acronym that just may be the key to you maximizing the value of your company.

The Link Between Owner Ambitions and Private Company Value

The priority and focus of the management of public companies is well defined: increase shareholder value. In fact, the board of directors in a public company has a fiduciary responsibility to do just that. However, the goals of private company owners vary and has a wide range of objectives.  Yes, most care about increasing the value that can eventually be monetized and reducing their tax obligations; but many have parallel ambitions and motivations; social, personal and community considerations weight heavily into their decisions. For example, some businesses seek to create jobs and provide employment for their community in a region that may be economically depressed or under privileged.  Some businesses are operated as a mission of Christ, seeking to evangelize and live-out the word of God and the work of the church. Others have legacy considerations and are managed as a means to provide family wealth and employment for generations to come… and the list goes on.  The mix of motivations and ambitions begins to define the eventual transfer channel or succession path for future ownership, which in turn defines the parties that will likely be involved in the future of the company.  The transfer channel and parties involved in that channel shape the approach in valuing the business.  So to the point, owner ambitions and motives directly impact the value of a privately held business.

My chart below is meant to provide a view of the concepts mentioned above.


Let’s discuss an example.  The owner of a privately held company desires to transition the business to his daughter, part of the transition being gifted with the remainder being purchased with a combination of bank debt and a seller note.  In our chart, that would fall under the bubble that indicates “Fair Market Value” which is governed by an IRS set of rules.  The concept of FMV has been litigated and is reasonably well defined… and most of the time tends to be on the lower end of the valuation spectrum illustrated above. So the decision to transition the business to family will likely result in a lower valuation for the business compared to the sale to a strategic buyer. Thus the ambitions of the owner directly impact the realizable value.  There is no judgment nor right or wrong; the point is to illustrate the difference between value that can be monetized and the inherent value to the owner that translates into social, family or community value.

Whether in Raleigh North Carolina, where we’re located, or in another part of the US… we’ve learned to begin the process of exit or transition planning with a discussion and understanding of what’s important to owners of the company, and how their business fits into their financial and personal ambitions.

Optimizing for M&A and Growth

Buddy and I recently wrote a chapter in the 14th volume of Advances in Mergers & Acquisitions, published last month.  The book (and chapter) are a bit academic, but there’s some good content and ideas that might be of value as you think about M&A.

We find that private, middle-market companies that choose to implement mergers, acquisitions or growth strategies in today’s environment often face challenges when engaging with the capital markets, particularly when bridging the valuation gap between market values and owner values[1]. The chapter we wrote applies traditional corporate finance theory to the real-world dynamics of private, middle-market companies and outlines practical steps to shrink the value gap and increase transaction readiness.

For private, middle-market companies – those companies with annual revenues from $5 million to $1 billion – value creation is principally based on long-term, expected future cash flow. In practice, the activities that lead to value creation are nearly the same when preparing for a financing, a wave of growth or an M&A transaction. Owners of private companies tend to manage the business to minimize taxes and maximize the current cash benefit to the shareholders. While this approach makes sense in the short-term, it often over-weights decisions and strategies for immediate impact at the expense of what outside investors or lenders would consider long-term value creation. Many times, improving the realizable value of a company means shifting its approach and stance from one that is reactive to one that is proactive. Taking a proactive stance means, among other things, a company will tackle tough issues and instill disciplines like those on which an institutional investor would insist. A useful question for management to ask in readying their company for change is “What would a private equity buyer do to improve my business?” The answer to that question will likely provide keen insights and areas of focus, and is what we hope to provide in this chapter.

Essential to increasing the value of a company is increasing the amount and certainty of its cash flow while reducing the risk of achieving that cash flow. Optimizing the business should result in both a shift in the market value of the company towards the upper-end of valuation benchmarks and increase its alternatives (more buyers, cheaper capital, etc.) when engaging with the capital markets. Our discussion here hinges on those value levers most critical to the optimization of private, middle-market companies from the perspective of those in the capital markets, including institutional investors, lenders and buyers.

Keep in mind that strategic decisions need to be thought of and developed by aligning the company’s long-term growth strategy with the right leadership team, with the appropriate entity and organizational structure supported by scalable systems, and capitalized by the proper funding sources. Management must also consider changes to a company relative to its stage and life cycle within its specific market.

Calculating the value of a stream of cash flow can be viewed in mathematical terms by this simplified formula[2].


According to this equation, we can increase value by increasing the absolute value of the cash flow, reducing the cost of capital or increasing the rate of growth of the cash flow (or any combination of the three). Reducing the cost of capital is, in part, directly related to the risk of achieving that cash flow. To frame the discussion and apply some basic corporate finance concepts, we will look at value creation and optimization of a private, middle-market company as an exercise with three distinct types of value levers: (i) pursuit of strategies that increase the return on invested capital, (ii) pursuit of strategies that reduce the risk of investment in the company, and (iii) pursuit of tactics and strategies that ease the transfer and reduce the company specific risk of transitioning a business to new owners (whether transferred in part or in whole).

Certain businesses don’t generate positive cash flow in the early phase of their lifecycle but do create significant inherent value. From a buyer or investor perspective, these companies may have captured (or are capturing) a significant customer base or developing a technology that will eventually lead to relatively large and material cash flows. These core concepts still apply.

[1] Owner value is the value of the business interest to the current owner, considering
the entire stream of value including both financial and personal considerations that
accrue to his/her total economic benefit. The risk implied by owners to this value
stream is usually less than what the market would otherwise impute, which exacerbates
the valuation gap.

[2]There are variations of this formula that account for fast growth businesses, and
for those with negative short-term cash flow and positive long-term cash flow.


The Value Gap

Our team at High Rock Partners is constantly listening to clients and observing market trends.  In a short video, we captured our view of the quandary of emerging growth and middle market company leaders.  The need and case for focusing on value creation has never been more prominent than it is now …businesses must pursue strategies to become stronger …not just to lead, but to survive and thrive.  Here’s a link to view the video  http://vimeo.com/53096085 The snippet ends by talking about our framework and tools to create value for shareholders; it is called Strategy Navigator™.

Also, here’s a link that talks about the Value Gap on Divestopedia.com


Last week we held our monthly National Funding Association meeting in Raleigh. Our guest speaker was Bill Hobbs, Managing Partner of Carousel Capital. Carousel is a buyout fund purchasing companies with at least $3 million of EBITDA located in the Southeast US. In addition to the industry trends and observations, Bill highlighted a phenomenon somewhat unique to our times; we’ve seen the same. That is, valuations for well run and good performing middle-market companies are strong and funding is available. Otherwise, valuations are depressed and deals tough to do …in many cases there’s no deal to be done. This makes sense given the back-drop of historically high dry powder in the coffer’s of private equity funds searching for deals to invest in. In fact, there is the greatest amount of overhang and pent-up capital ever for middle-market transactions.