How much does a quality of earnings report cost?

What has typically been reserved for private equity transactions and large M&A deals is now being used on Main Street. Many self-funded searchers and small business buyers are turning towards a quality of earnings report before closing on a small business acquisition. 

With most information online being restricted to quality of earnings providers focused on $100M+ M&A deals, small business entrepreneurs are left in the dark about how much a QoE report will cost for their deal and whether it’s worth it.

What is a quality of earnings report?

The purpose of a quality of earnings report is to surface significant risks and discrepancies between a business’s stated financials and its likely cash flows under a future owner. The findings are based on an accountant’s review of bank statements, financial statements (income statements, balance sheet statements, tax returns, etc.), and other data sources such as Quickbooks. 

Typically throughout the QoE process, the CPA will work closely with the buyer and, oftentimes, the seller’s own bookkeeper or CPA.

The goal is to understand:

1. How close is reported cash flow to actual cash flow? What about adjusted EBITDA?

2. What are the assets and liabilities of the business?

3. What are the working capital requirements for the business?

4. Are there any concerning trends in operations or finances?

A QoE will highlight issues for a prospective buyer and allow her to decide (a) are any of the issues worth bailing on the deal or renegotiating the Letter of Intent?, (b) is her current financing plan going to deliver sufficient working capital?, and (c) how can she best operate the business should the transaction close?

How is a quality of earnings report different from an audit?

An audit is solely focused on delivering correct financial statements and is often required for financing or regulatory needs. It is a much more regimented process than a QoE and, by its nature, less forward looking.

A Quality of Earnings is most focused on reviewing financials and performing a due diligence process in the context of a transaction. So, it is more forward looking with normalized and pro forma adjustments to EBITDA under a new owner. It will often be more custom and tailored to a buyer’s concerns and needs, with reporting on add-backs and adjustments to EBITDA.

Who can perform a quality of earnings report?

A quality of earnings exercise is typically done by a CPA firm or a financial due diligence provider.

While most small business CPA firms do not have formal QoE offerings, they are often engaged by a small business buyer to review financial statements and do a cursory review of whether the deal looks in line with other businesses of the same size or industry.

For a long time, financial due diligence firms only focused on larger deals and had minimum fees in the six figures. Lately, a number of firms have been founded that are focused on providing due diligence services specifically to small business buyers and have pricing that matches.

When choosing between engaging a local CPA and a financial due diligence firm, here are some factors to keep in mind:

1. Turnaround time: Most CPAs are busy and may take some time to get around to diligencing an acquisition target. Given that many small business buyers wait until later in the transaction cycle to perform a QoE, they may find themselves under the gun with lender and seller pressure. Financial due diligence firms can move fast.

2. Focus: Given that your average CPA historically works on historical numbers, they have a biased towards recasting the historic numbers. They may be less suited for forward looking projections of true cash flow.

3. Price: Working with a local CPA will often be much cheaper than a financial due diligence firm. Although it will come at the expense of speed and thoroughness, CPAs are great for buyers already familiar with a business or industry as well as those working on a tight budget.

How much does a quality of earnings report cost?

For lower middle market and larger deals, the ticket size for a quality of earnings report typically starts around $60,000 and quickly stretches into six figures. In the small business world, QoE providers are a good bit cheaper.

Firms like Pride Valuation, Builders.cpa and Guardian Due Diligence charge between $12K and $25K, depending on the complexity of the business and requirements from the buyer.

For entrepreneurs using investors or debt to finance their deals, they can roll the cost of a quality of earnings report into their total uses for the business acquisition. However, they normally need to pay the price upfront out of their own pocket prior to getting reimbursed from the deal.

Is a quality of earnings report worth it for a small business?

This is the question every self-funded searcher will wrestle with. In the words of the QoE industry, “do you have $1M to lose?” Their stance is that $25K is a small price to pay for avoiding buying a fraudulent or misrepresented business. Additionally, they may argue that the issues you find will allow you to get concessions on the business valuation or purchase price that make up for its cost.

However, that’s still not a trivial amount of money given that a majority of transactions will fall apart before close. Buyers could find themselves paying for 3-4 quality of earnings reports before actually closing on a transaction.

At the end of the day, whether to order a quality of earnings report depends on a business buyer’s risk tolerance, confidence in the financials and business, and ability to perform due diligence on their own.

We typically see quality of earnings reports be used for small business acquisitions north of $2.5M.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.