Quality of Earnings Analysis: A Seller's Thing Too?

Seller beware: in the midst of negotiating almost any deal, leverage remains with the seller until the Letter of Intent is executed. Post execution of the LOI, the balance almost always tilts in favor of the buyer. Make no mistake about it, the sale price of your company will never go up once you’ve affixed your “John Hancock” to this seemingly innocuous document.

So how does a seller maintain the scale’s balance during the buyer’s due diligence process? Cue the seller’s preemptive Quality of Earning analysis, the potential ace in the hole that can be a critical tool for helping to maximize deal values, avoiding last-minute surprises, and maintaining deal momentum. This white paper explores why we believe founders and owners of lower middle market companies should embrace the preemptive Q of E analysis as an integral part of their pre-sale strategy.

The Value of a Q of E Analysis for Sellers

While founders have deep knowledge of their business operations, they often lack the objective, third-party validation that investors and acquirers require. According to a study by the National Center for the Middle Market, 54% of failed deals cite "financial surprises" uncovered during due diligence as a contributing factor. Conducting a preemptive Q of E analysis beforehand helps mitigate this risk.

A Q of E report analyzes the accuracy, quality, and sustainability of a company's earnings, distinguishing between recurring and non-recurring revenue and identifying working capital trends.

For sellers, this analysis:

Builds credibility with prospective buyers
Reveals red flags before buyers discover them
Buttresses earnings and EBITDA adjustments in advance of going to market
Informs IOI range credibility and corresponding LOI terms

Identifying Problems & Finding Solutions: Accounting for Red Flags

Common issues discovered in Q of E reports include:

Misclassified expenses or revenues
Excessive reliance or revenue concentration with a single customer
Improper revenue recognition
Deferred revenue inconsistencies

If these or other financial issues surface during the buyer’s due diligence, they can erode trust and selling price. Addressing these potential obstacles in advance provides the seller time to clean up records, consult experts, and prepare appropriate narrative explanations.

Make the Buyer Incur the Q of E Report Costs: What Could Go Wrong?

Relying solely on the buyer’s Q of E analysis means losing control of the narrative and the process. If a prospective buyer’s findings differ significantly from the seller’s internal reports, it may lead to:

Price renegotiation or retrade
Extended closing timelines
Escrow requirements and/or holdbacks
Deal termination

Rather than reactively trying to defend numbers post-LOI, the preemptive seller’s Q of E report enables proactive communication and confidence in financial representations in advance of receiving any LOIs.

The Trusted Bookkeeper vs. Audited Financials

Long-standing, in-house bookkeepers often manage financial records well enough for day-to-day operations. However, these records are rarely maintained to GAAP standards or designed to withstand due diligence scrutiny.

A Q of E analysis, while not a full audit, bridges the gap between basic bookkeeping and buyer-grade financials by, among other things:

Ensuring accrual-based accounting is applied properly
Adjusting for owner-related expenses
Highlighting normalized EBITDA

In some cases, especially for larger deals and PE buyers, audited financials may also be required. Nonetheless, the surprisingly less expensive Q of E report can often satisfy buyer concerns.

Client Contracts and Multi-Year Revenue Recognition

If your business operates with long-term contracts that span fiscal years, you may face revenue recognition challenges. Under ASC 606, revenue must be recognized based on the satisfaction of performance obligations, not merely when cash is received.

Failure to account for this properly can:

Inflate or deflate earnings inappropriately
Confuse buyers evaluating recurring revenue or backlog
Trigger accounting reclassifications during diligence

A thorough, seller-led Q of E analysis will assess these contracts in advance, ensure proper revenue recognition practices, and reduce the risk of financial restatements derailing the transaction.

Legally Keeping Your Thumb on the Scale & Maintaining Balance

The preemptive seller’s Quality of Earnings analysis is a proactive, value-enhancing step that arms the business owner with facts, clarity, and confidence. It accelerates the sale process, strengthens negotiating power, and can help protect the deal from preventable pitfalls. Rather than a buyer-centric tool, we believe the Q of E analysis has become an indispensable component of a successful exit strategy for sellers in today’s competitive M&A landscape.

Sources:

National Center for the Middle Market, "Middle Market M&A Outlook," 2023
Deloitte, "M&A Trends 2023: Deal Activity Expected to Accelerate"
PitchBook, "Quality of Earnings in Private Market Transactions," 2022
PwC, "Revenue recognition under ASC 606: A guide for private companies"

This information is intended to be educational and is not tailored to the investment needs of any specific investor. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. Opinions expressed are those of the author and are not necessarily those of Raymond James.