Quality of Earnings - is it actually necessary?

November 18, 2019

by a searcher from Dartmouth College in Allentown, PA, USA

Searchfund fam,

I am under LOI on a $10mm purchase price deal. I have four months to complete diligence.

I know "best practice" in the search fund community is to complete a QofE. That said, all advisors that I'm working with on my search (my lawyer, buyside banker, etc.) have suggested that a QofE would be a waste of money for this deal.

I do not want to re-trade this deal - so I see no value in the QofE for those purposes. That said, a QofE would give me a lot of comfort in closing the transaction and stepping into operate the business. The company is a small manufacturing operation ($10.5mm in sales; $2mm in EBITDA). The company has used a very small CPA firm throughout it's history, and the financial records are not pristine - so there would be some comfort in getting the numbers checked. I believe the owner is an honorable man, and I do not believe there are any skeletons in the closet intentionally being hidden.

So my question: what are the real benefits to getting a QofE done at this point in time? Thank you for any guidance and perspective

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

In my teachings, I suggest following in sequence when buying a business by a first-time buyer 1) get comfortable with the demand side of the business, 2) your ability to manage it and your comfort in doing so, and 3) then QofE###-###-#### Few pointers a) Look at multiple years of earnings. b) Typical DD gives you one year of QofE by looking at 3 years of financials, c) analyze at least 5 years of financials(Lately I at least look at 1o years of sales, not necessarily profits) , d) QofE by itself is not enough. Cash flow is. Analyze why earnings are not going to shareholder? e) A business with high assets could be easy to buy and may make one feel more secure, but those are difficult to grow (generally stay away from those; don't waste time), f) Do Delta analysis of earnings, g) Small business owners typically under-report inventory, not over-report (one answer mentions 11 years of inventory. I doubt if tax returns show that. Also, QuickBooks has a format that shows cumulative purchases as inventory. I have often been misled by that). I can go on for hours, but would stop here.

Reply by a searcher
from Tufts University in Jersey City, NJ, USA

QofE is insurance: It's a "waste" until it isn't. If you're super confident in the quality of your own analysis, you can possibly skip it, but I'd generally advise against skipping it for any deal that you can't afford to be "wrong" on. Even if you feel you're skilled/competent to have done locktight diligence, outside eyes can provide an unbiased double-check before you make a meaningful and irreversible investment.

+23 more replies.

Join the discussion