Driving Business Value in a Sale or Capital Raise: The Sellside Quality of Earnings Report

A business sale transaction can be thought of as a war between the buyer and seller over the financial numbers of a company. For business owners and executives that are in exit planning mode and looking for methods to drive value in a business sale, there is an impressive tool that they can utilize: the sellside quality of earnings report (“Sellside QofE”). Prior to the development of this tool, business sellers and their investment banking advisors were often left exposed and relatively unprotected against the shrewd buyer corporate development teams and their buyside transaction accounting representatives. However, with the evolution of the Sellside QofE, companies that are selling and raising capital have a new line of defense, means to protect, and enhance value and ability to increase the chances of closing a transaction (i.e. “certainty to close”).

Understanding the Sellside Quality of Earnings Tool:   The Sellside QofE term can be very confusing, so it is important to define what this offering is. In simple terms, it's a comprehensive analysis and review of a company’s financials, conducted by an external, independent and objective transaction accounting firm. In many ways, an owner can think of a Sellside QofE as an audit of a company’s financials but with a specific M&A objective and with the intent of benefiting the company that is selling or raising capital.

The Sellside QofE can be broken down into two parts, the quality of earnings data pack and the full quality of earnings report. Many transaction accounting firms can offer just the core financial analysis, known as the data pack, which is presented in an excel workbook. In addition, the transaction accountant can provide a full Sellside QofE report, which includes both the data pack and a thoroughly written report that provides additional context and details. If a client opts for just the quality of earnings data pack, then that can often be less expensive than the full Sellside QofE report.

Why Is It Important? The primary purpose of this report is to validate and strengthen the financial position of the selling company, making it more attractive to potential strategic buyers or financial sponsors (i.e. private equity, family office, institutional investor). The business valuation that a Letter of Intent stipulates, and the final terms that are included in the purchase agreement, are underwritten based on the target company’s performance. To provide further definition regarding a Sellside QofE and how it helps drive value, it is helpful to break down the specific attributes the SellSide QofE and the transaction accounting firm provide to the selling business and its investment banking advisor.

• Credibility and Validation: Strategic buyers and financial sponsors are always vigilant when it comes to due diligence, and they are often skeptical of the legacy accounting and in-house financial resources that collaborate with the selling company. The Sellside QofE, performed by an independent and experienced transaction accounting firm, provides an outstanding one-two punch in a sale process for the benefit of a seller. The seller’s financials, which the buyer uses for underwriting an offer, are not only validated, but that goal is accomplished by a pedigreed transaction accountant that has immense credibility. Furthermore, seasoned buyers usually treat the selling company’s numbers with more respect if they have been vetted and presented by an industry peer.

• Accrual-Based Accounting: It isn’t uncommon for selling companies to utilize cash-based account for their financial records. The market of buyers, whether it be strategic or financial sponsor, underwrite valuations and LOI terms on GAAP[1] accrual accounting procedures. When a buyer’s transaction accounting firm converts a selling company’s financials to accrual basis accounting during due diligence, there is a risk that it presents financial performance that is materially different than those used to formulate an offer. The buyer then has an excuse to retrade on the seller.  An experienced transaction accounting firm will convert the company’s financials to GAAP accrual basis as part of the Sellside QofE analysis, limiting the risk of a retrade.   

• Defensible and Enhanced EBITDA: In many industries, the Adjusted EBITDA[2], or operating cash flow, is a key metric that buyers underwrite on in a transaction. With some exceptions, this is the most used metric for valuation discussions in a Letter of Intent[3] (“LOI“). The seller’s objective is to present the business with the highest possible adjusted EBITDA, which then drives the value in the deal. The Sellside QofE process involves identifying opportunities and adjustments to increase the Adjusted EBITDA, making it as defensible and attractive as possible. A quality transaction accounting firm will find ways to create value in a sale by proving a higher adjusted EBITDA.

• First Line of Defense: When a buyer conducts its due diligence, it typically hires its own transaction accounting firm to do a buyside quality of earnings reports. These buyer representatives have a fiduciary obligation to their client to try to demonstrate a lower financial performance for the target company, which can then give the buyer the excuse to “retrade” down on the agreed upon valuation and terms in the LOI. During the buyer’s due diligence effort, the seller’s transaction accounting firm can serve as the protector of the company financials, and the original offer terms, by taking control of the financial due diligence conversations. The seller’s transaction accounting firm takes a great deal of pressure off of the owner and his investment banking advisor, and it reduces the chances of a retrade.  

• Additional Support Before and During the Process: Preparing for the company’s financials and systems for a sale, and then managing those same systems during a sale process is a complex endeavor. Many transaction accounting firms can provide advice and CFO-like services prior to a sale process. Furthermore, and in addition to the Sellside QofE, the transaction accounting firm can continue providing these additional financial support services during the life of the sale or capital raise process.

The Cost-Benefit Analysis: One common question business owners have is, "What will it cost me, and is it worth it?" Many factors drive the cost, including the complexity of the company, the accuracy of the financial systems in place, the size of the deal, and the capabilities of the in-house financial team that can work directly with the transaction accounting firm. Bundy Group has seen Sellside QofE’s go as low as $30,000 and as high as $300,000. A transaction accounting firm should be able to provide detailed pricing or an estimate prior to an owner engaging one of these accounting firms. Hiring a sellside transaction accounting firm can be considered an investment for several reasons, including:

• Credibility Pays Off: The credibility and validation provided by the Sellside Q of E report and the transaction accounting firm can make or break a deal. It can mean the difference between retaining value or a costly retrade…or even a blown deal.
• Increase Value: A defensible and enhanced EBITDA, driven by the transaction accounting firm’s Sellside QofE, can result in a higher transaction value for a business, often far exceeding an owner’s original expectations.
• Protect Value: The Sellside QofE serves as a shield against potential disputes over a company’s financial figures, potentially saving an owner millions due to offer retrades.

Takeaways:

Owners of companies that are preparing for a sale or raising capital should remember that the buyer and its transaction accounting representative are not their friends. Their intent in due diligence is not benign but to use the company’s financials against the seller to gain an advantage on valuation and structure terms.  It is essential to recognize the pivotal role that a Sellside QofE can play in driving value in a transaction. By investing in a Sellside QofE, in conjunction with an investment banking-led process, an owner can not only increase the credibility of the financials but also maximize the value of its business. Buyers are in the business of trying to acquire quality firms for low valuations, and Sellside QofE is one of several mechanisms that an owner can utilize to counter that buyer [play].

Don't hesitate to reach out to the Bundy Group team, who can provide further thoughts on how to drive value using competition and a Sellside QofE. With the right team and strategies in place, an owner can confidently navigate the complex world of business sales and achieve the best possible outcome.

Don't hesitate to reach out to the Bundy Group team, who can provide further thoughts on how to drive value using competition and a Sellside QofE. With the right team and strategies in place, an owner can confidently navigate the complex world of business sales and achieve the best possible outcome.

[1] Generally Accepted Accounting Procedures

[2] Earnings Before Interest Expenses, Taxes, Depreciation and Amortization. Adjusted for one-time and non-recurring expenses.

[3] Letter of Intent is the formal offer, negotiated out by the buyer and seller, which stipulates the key terms for the transaction to be underwritten on.