In merger and acquisition transactions, a quality of earnings (QofE) analysis is an important piece of financial accounting due diligence. A reputable independent accounting or other advisory firm that has an extensive background in conducting financial due diligence and expertise in the target company’s industry should be used to prepare the QofE report, which involves several stages, including data collection, analysis and reporting. The analysts will review the company’s financial statements and other documents, conduct interviews with key personnel, and analyze relevant industry data. In order to complete the QofE report, the financial statements, general ledger, tax returns, management reports, certain sales and vendor contracts, and other documents and records pertaining to the company’s financial performance will be examined. The data will then be analyzed to identify the financial strengths and weaknesses of the company. The QofE report will provide a complete picture of the company’s financial health and will also identify potential risks and uncertainties.
Buyers regularly engage an independent firm to produce a buy-side QofE as part of their due diligence with respect to a target company. Many sell-side M&A advisers have recently encouraged the target company to obtain a sell-side QofE early in the M&A process because of the benefits it brings to the seller’s transaction. A sell-side QofE that is prepared before the marketing of the target company to potential buyers begins can result in significant advantages for the seller, including the following:
- Validating EBITDA: As M&A transactions are typically valued as a multiple of adjusted EBITDA (earnings before interest, taxes, depreciation and amortization expenses, adjusted for nonrecurring revenue or expenses), the ability of the seller to validate the target company’s adjusted EBITDA based on the QofE’s independent analysis is very beneficial to defending the value for the target company that is being sought by the seller.
- Identifying Issues Earlier: The sell-side QofE may uncover issues that could negatively impact the sale process. Such issues, when identified early, before commencing the marketing of the target company, can potentially be resolved or a strategy can be developed to address the issues.
- Expediting Due Diligence: As a result of the sell-side QofE process, the seller will have already assembled and analyzed many of the documents and the data that the buyer will be requesting as part of its due diligence. Such advance preparation will accelerate the deal process and free the seller’s management team from searching for and compiling data, allowing them to instead address other transaction matters and continue running the target’s business. Further, the sell-side QofE provides a practice run of what the seller and its management team, particularly the chief financial officer, will face during the buyer’s due diligence and will enable the buyer to progress through its due diligence more efficiently.
- Supporting Working Capital Calculations: The sell-side QofE will help establish the appropriate components of the working capital calculations and support the determination of the target net working capital required to operate the business. The working capital mechanism is often an area of potential disagreement in M&A transactions. A QofE can help avoid vagueness or uncertainly and post-closing disputes in connection with the working capital determinations in M&A transactions.
Engaging an independent firm to produce a sell-side QofE is becoming common practice for sellers, largely due to the benefits of supporting the purchase price and facilitating the process, thereby leading to a successful closing.
Meet the Author
Thomas Ix focuses his practice on mergers and acquisitions, joint ventures, contract negotiations and general corporate matters. Tom has extensive experience in middle-market mergers, stock acquisitions, and asset transactions. He represents clients in a variety of industry sectors, including manufacturing, distribution, financial service, plastic packaging, recycling, outdoor advertising and specialty chemicals.
tix@stradley.com
215.564.8030
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