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A Quality of Earnings Study Can Make A Business Sale Smooth Sailing

May 4, 2021

After years of hard work to build your business, now may be the time to strike the sale while the mergers and acquisitions market is hot. What you need is a plan to start the selling process and key to the plan is communicating the value of the business.

How do you prove that your business is worth what you think?

An objective and fair measurement of a company’s performance hinges on the financial data. The very first item a buyer will likely focus on is “earnings” (net income) because it is the key indicator of profits/losses. 

However, there are many elements and factors that impact the “earnings” number. You may want to provide a bit more background if earnings during a particular period are unusual. For example, 2020 certainly taught us that there are unpredictable circumstances that will cause a company to have an “unusual” performance year. As we have seen in this past year, there were winners and there were losers.  If we evaluate a company solely based on its earnings, it may not accurately represent the true financial picture. Some additional considerations should be factored in.  As such, the word we emphasize here is “quality” in order to provide a more comprehensive and accurate view of a company’s financial health.

How do you communicate the quality of earnings? 

A pre-sell Quality of Earnings (QofE) report is an effective way to achieve this purpose. So, what is a pre-sell QofE report and why does it matter? 

In much the same way that interested buyers want to investigate (due diligence) the business to extract maximum value from transactions, you, as the owner of the business, want to capitalize the maximum value of the business you worked hard to build. A pre-sell QofE report essentially does the due diligence work for a buyer, while giving you an opportunity to address potential questions or issues that may arise during a buyer’s due diligence process in advance.  

For example, your company may have reported positive earnings quarter after quarter, but in 2020 due to the unexpected lock down period and overall uncertainty as a result of the pandemic, the company had negative earnings for the year. It was unprecedented and unforeseeable and hopefully not a repeatable event. This type of one-time event or item should be taken into account to normalize the financial result for the year. Contrarily, if you were able to quickly react to the sudden market shift in innovative and creative ways, such quick crisis management adaptability should be highlighted for its value.

On the flip side, if your company has been reporting mediocre earnings for some time but due to a change in a company policy or accounting method, the company swung into a highly profitable position, the change should be reviewed for fairness and ultimately “normalized”. In either case, a sensitive seller or buyer needs to look beyond the “quantity” an earning represents and examine the “quality” of earnings.    

Why does a QofE matter?

Although a QofE review is not mandatory in a business deal, a prudent, conscientious buyer will likely go through the earnings review process in order to determine whether it is worth the investment. The process may also spark negotiations on price. As the business owner, you want to be well prepared when a potential buyer raises questions in their own quality of earnings review process. Consider it a form of internal audit, whereby you take a critical look at what is driving the value of your business and where value-generating improvements can be made. Be ready to discuss those items with potential buyers and be willing to accept or reject adjustments identified with your own logic and reasons.

History has shown that many business deals don’t close due to the inability of the buyer and seller to agree on specific issues or terms. A typical business sale is a six- to nine-month process. If, at the end of this lengthy and labor intensive exercise, both sides reluctantly conclude that it is not a fit, both parties walk away feeling frustrated. As a seller, the effort and time demanded from the selling process inevitably takes your focus away from day to day operations. Furthermore, an unsuccessful sale sometimes not only disrupts business operations but also challenges your confidence in the business. 

To avoid surprises, it is highly beneficial to take time to conduct a thorough pre-sell quality of earnings study prior to putting the company on the market. You may want to consider engaging a professional firm, such as MarksNelson, to assistant you in the study.  An objective outside assessment will provide a fresh and independent view of the business value, as well as minimize disruption to the business. Another added benefit of a pre-sell QofE study is the affirmation of the business value which can be persuasive in attracting interested buyers.   

If you are considering the possibility of selling your business, a pre-sell QofE study is a worthwhile endeavor.  The study will force you to self-examine the business value and reveal the strengths and weaknesses that may need to be addressed before going to the market. It makes the selling process smoother and more efficient. If we can help, give us a call to discuss your unique situation.
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MarksNelson
Communications

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