Step One - LOI Signatures
The small business sale process will inevitably require some level of due diligence as prospective buyers attempt to learn a company’s operations and financials. As conversations with acquirers progress, diligence becomes more granular and entails a depth of analysis that is important for confirming the accuracy of business information.
The most comprehensive review of the business’s financial, operational, and legal matters typically begins after a Letter of Intent (LOI) is signed. A Letter of Intent grants exclusivity to a specific buyer and represents a commitment from the seller to pause conversations with other buyers during the exclusivity period defined in the LOI. The LOI includes proposed transaction details, such as purchase price and structure, but also includes a condition that states the transaction is subject to satisfactory completion of due diligence.
At the heart of financial due diligence is the Quality of Earnings (QoE) report. While buyers commonly request QoE reports to validate accounting and financial accuracy, sellers can also benefit by proactively commissioning a QoE report. Here’s how a QoE report works, what it includes, and why it can be a valuable tool for sellers navigating the sale process.
The Due Diligence Stage: A Pivotal Step After the LOI
The due diligence stage usually follows the signing of the LOI. Recall that LOI’s are non-binding agreements, meaning transaction terms are agreed to in principle, pending confirmation of the information shared by the seller. At this point, the buyer has expressed serious interest and needs to confirm that the financial and operational details of the business align with the seller's claims.
Due diligence covers several areas, including:
Financial Due Diligence: Verification of revenue, expenses, cash flow, and working capital.
Legal Due Diligence: Review of contracts, intellectual property, and legal obligations.
Operational Due Diligence: Assessment of processes, technology, systems, and team performance.
If discrepancies or financial inconsistencies arise during this stage, they can lead to price reductions, renegotiations, or even the deal falling apart altogether. This is where a Quality of Earnings report can play a pivotal role in confirming the financial accuracy of the business.
What is a Quality of Earnings (QoE) Report?
A QofE is a detailed analysis of a business’s financial performance that goes beyond standard financial statements to provide a clearer picture of its true earnings power. Unlike traditional financial reports, which present income, expenses, and profits as recorded by a company’s internal accounting process, a QoE attempts to recreate accounting steps in accordance with accepted accounting standards. This can mean adjusting for non-recurring events, discretionary expenses, timing of revenue or expense recognition, and other anomalies that are addressed to present normalized earnings—a more accurate representation of the business’s sustainable profitability.
Key Components of a QoE Report:
Revenue Analysis: A breakdown of revenue streams, including trends, customer concentration, and seasonality. Accrual adjustments for revenue recognition.
Expense Adjustments: Adjustments for one-time expenses, owner perks, and non-operational costs. Accrual adjustments for expense recognition.
EBITDA Adjustments: Normalization of earnings before interest, taxes, depreciation, and amortization to show consistent profitability.
Working Capital Analysis: A review of the business’s working capital needs to maintain operations.
Cash Confirmation: Review of bank statements, cash inflows and cash outflows to confirm accuracy of cash reporting.
How the Quality of Earnings Process Works for Sellers
When a seller commissions a QoE report, the process typically follows these steps:
Engagement with Financial Experts: The seller hires a reputable accounting firm or CPA firm experienced in small business sales to perform the QoE analysis.
Data Collection: The accounting firm gathers key financial documents, including income statements, balance sheets, tax returns, bank statements and customer contracts.
Analysis and Adjustments: The firm conducts a deep dive into the financial data, often rebuilding accounting reports to identify anomalies, non-recurring items, and potential areas of concern.
Report Delivery: The finalized QoE report is delivered, providing a comprehensive and objective view of the business’s earnings quality.
Commission a Quality of Earnings Report - Benefits for Sellers
While a QoE report is often seen as a buyer's tool, sellers who take the proactive step of commissioning their own QoE report stand to gain several advantages:
1. Increased Credibility and Transparency
One of the biggest fears buyers face during due diligence is uncovering surprises that may indicate hidden issues or misrepresentations in the financials. By presenting a third-party QoE report upfront, sellers demonstrate transparency and build buyer trust, making it less likely that the buyer will question the financials or feel compelled to renegotiate the terms of the deal.
2. Smoother Due Diligence Process
Due diligence can be a long, tedious process that delays the closing timeline. By having a QoE report prepared in advance, sellers can streamline the process because much of the heavy financial analysis has already been completed by a reputable third party. This allows buyers and their advisors to move more quickly and efficiently.
3. Identification of Red Flags Before Buyers Find Them
A QoE report can help sellers identify potential red flags before the buyer’s due diligence team uncovers them. For example, if the report highlights an over-reliance on a single customer or inaccurate revenue recognition practices, sellers have the opportunity to address these issues—or at the very least, be prepared to explain them—before they become sticking points in negotiations.
4. Stronger Negotiating Position
Small businesses often prioritize elements of operations that take precedence over accounting and finance infrastructure. By commissioning a QoE report, sellers can gain deeper insights into the true financial health of their business and be better prepared to defend their asking price during negotiations. The report can support the valuation by presenting a normalized view of earnings as they would have been stated under accepted accounting standards, reinforcing the justification for the proposed sale price.
5. Better Preparedness for Pre-LOI Conversations
In competitive sale processes, buyers will request preliminary financial data even before the LOI is signed. Having a QoE report can instill confidence in the shared information, and enables sellers to present a clear and accurate financial picture early on, potentially attracting stronger offers and faster LOI commitments.
6. Avoiding Post-Sale Adjustments
Post-sale disputes over working capital adjustments or earn-outs are common in small business sales. A QoE report can help clarify how working capital is calculated and prevent misunderstandings about what constitutes “normalized” earnings, reducing the risk of post-sale conflicts.
When Should a Seller Commission a QoE Report?
For many sellers, commissioning a QoE report well before the due diligence phase begins—often at the same time they decide to put the business on the market—can provide the greatest benefit. Early preparation allows time to make any necessary corrections and present a stronger case to prospective buyers.
However, even if the business is already under LOI, commissioning a QoE report can still help sellers defend their valuation, speed up due diligence, and provide a critical advantage during final negotiations.
Concluding on Seller Provided QofE
A Quality of Earnings report is not just a tool for buyers. It’s a powerful resource for sellers seeking to maximize their sale price and close the deal with confidence. By commissioning a QoE report, sellers can present their business’s financials in the best possible light, mitigate surprises during due diligence, and reinforce trust with potential buyers.
In a process where transparency and preparedness can make or break a deal, the proactive approach of obtaining a QoE report can lead to smoother negotiations, fewer delays, and a successful sale at a favorable price. If you’re considering selling your business, investing in a QoE report could be one of the smartest steps you take.
