When you’re buying your first business and you get a look at the financials, you’ll find your eyes always drop to the bottom line. You want to know just how much this business brings in. But revenue on its own has a way of hiding what really matters. A company can show growth for years and still fall apart the moment you buy it. At QoE Prep, we ask a simple question: what do these numbers actually mean? Are they reflective of real value or are they just a pretty bow on top of a heap of you-know-what? I got the chance to break down how my team and I work to discover the meaning behind these numbers in an interview with @redacted‌. He is a Managing Partner at Search Fund Ventures, where he backs acquisition entrepreneurs and independent sponsors building the next generation of small businesses. He also founded the SMB Investor Network, a community of over 3,000 members that connects investors with qualified searchers. Here’s a breakdown of what we discussed (and if reading’s not your thing, here’s the link to the interview). The Revenue Behind the Curtain Not all revenue is created equal. Some is sticky, some is lucky. It’s good to have recurring customers, but not if they’re all tied to one salesperson. A business where the owner makes every sale might look healthy by the numbers, but it can all collapse the moment that person leaves and a new owner comes in. When you’re buying a small business, a lot of times you’ll find that the owner is the one making all the sales. For example, it’d be hard for me to sell my business because someone would have to replace what I do (which is a lot). So that’s one sign of risk. There are plenty of other “tricks” that people pull to make their numbers tell a different story. I worked on a fitness company that seemed really perfect once. It ran on monthly memberships, the books were clean, and revenue was growing. Then, just before selling, the owner changed all the memberships from monthly to annual. So, he collected a full year of payments up front. In doing that, it looked like there was this huge inflow of cash, but in reality, the new buyer was about to buy a company without any incoming cash for a year. The deal never closed. The buyer walked away because the two parties couldn’t trust each other enough to get the deal done. Working Capital or Capital-ly Working? Even when revenue checks out, the next problem is what the seller leaves behind in terms of working capital. Every business needs working capital to stay alive, but right before a sale, sellers sometimes try to hold onto cash or push off bills. Let’s say I wanted to sell my HVAC company in three months, as one does. I have all these bills coming up, and I decide I’m not going to pay any of them because it’s not my problem anymore. It’s the new owner’s company, so it’s gonna be his problem. That’s the thought process of a lot of small business owners looking to sell. That’s why we build a working capital peg when we create our quality of earnings reports. It’s a baseline that keeps both sides honest. The seller has to leave enough in the bank for the business to keep running. It’s like selling a car: you’ve got to leave a little gas in the tank so the new buyer can drive it off the lot. Without that peg, you’re buying a car that can’t leave the driveway. Keeping an Eye on Seasonality Working capital also depends on timing. Some businesses make half their money in a single season. If you buy in the off-months, you could inherit payroll with no cash flow to cover it. A landscaping company in the Northeast might make 40% of its total revenue in one quarter. So, if you buy in January, you’re walking into months of payroll with very little cash coming in. Understanding when the business actually earns money can sometimes be just as important as knowing how much it earns. Patterns in Costs and Revenue The last question I like to ask is how much it costs to keep things running. When we study a business, we want to know whether costs move with revenue or against it. Are they fixed, or do they rise and fall as the business grows? For example, if revenue’s going up but margins are going down, it means the company is not pricing things right. I’m always looking for patterns like that. Once you’ve spotted a pattern, you can try to dig into the reason behind it. Sometimes it’s bad bookkeeping. Sometimes it’s inefficiency. Either way, it tells you what life will look like after you own the business. Seeing What’s Really Real A quality of earnings report is our tried-and-true method for understanding what the numbers actually mean. We want to know what’s really going on so that you’re not just throwing a dart when you buy your next business. If you’re interested in learning more about what a quality of earnings report can do for you and your business, go to our website to get a free quote today.