How to structure quality-of-earnings diligence to manage and minimize cost

Search funds have limited resources. One of the frequent questions we hear from a searcher is about how much a Quality of Earnings (QoE) report costs and how we structure the arrangement in the event of a broken deal. Hood & Strong has been in the search fund community since 2004 and we understand how the search fund model works. In this article, we will share several ideas about how to structure, manage, and even shift the burden of cost to the seller, while getting the most value out of your accountant.

Defining the scope of work

The scope-of-work on the financial due diligence drives the cost, but there is no uniform standard or style of presentation for a due diligence report in the accounting industry. The quality of earnings is a part of financial due diligence that should be very focused, and agreed upon between the searchers and accountants, on the significant accounting areas of the business and industry, and should not waste an inordinate amount of time on accounting matters insignificant to the business and transaction.

Not only should a focused quality of earnings report provide cost savings to the searcher, it should clearly and succinctly present significant findings and recommendations, provide relevant perspective on key earning components and adjustments, and a standard set of financial statements that include income statements and balance sheets as expected by the lenders and investors.  For the typical search fund targets, our cost of a quality of earnings report includes the standard package of a quality of earnings analysis, working capital analysis, limited tax diligence, and adjusted financial statements.

Risk-sharing arrangement on broken deals

It is standard for accountants that practice M&A due diligence to offer a deferral on fee payment until the deal is closed. In addition to fee deferral, accountants in the search fund community should also be able to structure a risk-sharing arrangement with the searcher whereby the fees are adjusted for broken deals or rolled over to a future deal. You should talk to your accountant about the specifics of the arrangement. Nonetheless, both are attractive options for a searcher that is working with limited resources, which also speaks to the underlying confidence and experience of the accountant in the search fund model and the searcher.

When to contact and engage your accountant

Often times, the searchers contact us after a letter of intent (LOI) is signed.  Jim Stein Sharpe wrote a very informative article about the quality of earnings where he cautions on starting the accounting diligence too early. We generally agree with Jim’s view on this. But to expand and clarify our perspective, we think it is never too early for the searcher to contact us. When you are drafting the letter of intent and contemplating the important terms, you should use your accountant as a resource. A good accountant should have a deep breadth of experience in the business and industry to weigh in with feedback and pitfalls, and provide you with a relevant perspective, such as how to think about the working capital and its impact to overall valuation of the company, and how to structure the NWC peg accordingly. The accountant should also provide the seller’s perspective and anticipate the seller’s push back on significant terms such as the implication of an asset versus stock deal that may require making the seller whole.

We encourage the searchers to contact us early even before engaging us on the due diligence. We enjoy talking about the deals and serving as a sounding board. We don’t charge by the hour for the questions we get, unless the questions require a significant amount of work or research, which, of course, we would let you know about in advance. Sometimes through our early discussions, we may be able to help set the focus and identify potential key areas of concern before anyone gets too invested.

Managing the costs in phases

There may be times when we need to get involved as soon as the LOI is signed before the searcher has performed some level of diligence on his or her own. A situation where our engagement may be necessary so early is when there is no confidence on the reported EBITDA due to cash-basis reporting.

In those situations, we recommend managing the cost by structuring a multi-phase process for financial due diligence. The first phase of the work includes scrubbing the numbers and adjustments, determining a preliminary TTM adjusted EBITDA, and identifying the areas of potentially significant issues. For the first phase of the work, we typically need the basic information of a CIM, LOI, and financial statements for the trail twelve months. The cost of phase one typically is a small fraction of the overall costs and helps the searcher to minimize and manage the costs.

If everything still looks good after phase one and the searcher wants to proceed with the transaction, then we begin the second phase to complete the full diligence of historical EBITDA, adjusted financials, working capital analysis, tax diligence, etc.

Seller paying for the quality of earnings analysis

In certain situations where the seller is really motivated to sell or demands a hefty price for the business, or the buyer is on the fence, there may be an opportunity push the seller to bear the cost of performing a quality of earnings analysis. We have successfully advised our clients to use this strategy and convince the sellers to perform sell-side due diligence. The key considerations for the seller are to help the seller prepare for the sale and increase the chance of a successful deal. If there are issues in the company, the seller would want to know them and resolve them early to command the price they want. To incentivize the seller to pay for the due diligence upfront, the buyer can reimburse the seller upon a successful close. If the seller is confident in the business and its earnings, there is no reason not to do it.  Even if the deal doesn’t close, the seller can keep and use the report for the next buyer. If negotiated properly and successfully, it is a win-win for all parties.

If you have feedback, thoughts or comments on this article, please me at jzhou@hoodstrong.com.  I would be happy to have a conversation with you and learn where you are in your search process.

Jerry Zhou, CPA
Director
Hood & Strong LLP
jzhou@hoodstrong.com

 

 

 

 

 

 



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