In case you haven’t heard, the SBA has made it official that quality of earnings reports are now required on deals financed through its loan programs. Considering how much the ETA movement has exploded, the mandate isn’t a huge surprise. Most people who know what they’re doing in this field have already been using QoE reports. When I say “most people,” I could also just say “closers” since that’s typically what happens when you approach a deal the right way. If someone’s deal does fall apart, they will likely get a QoE the next time around. Unless you’ve got a penchant for losing back-to-back like a certain NFL team. I spoke with @redacted‌, an experienced and extremely competent broker, about all that goes into seeing deals through. In case you missed it, we recorded our whole conversation. redacted A Broker’s Eye for What’s Real Jackie has been selling businesses sinceredactedShe started with a heavy volume of small Main Street deals and over time moved into larger, lower-middle-market transactions. Despite nearly three decades of experience, she treats every business as a one-of-a-kind entity, even if she’s worked on several businesses in the same sector. She helps owners get their businesses ready to sell by setting them up to navigate the largest pitfalls in M&A deals. Negotiation-ception As much as we’d all like to take a page out of Don Corleone’s book and make someone an offer they can’t refuse, we’re inevitably going to find ourselves negotiating in an M&A deal at some point. There are plenty of problems that can lead to an offer being refused. None of them are solved by decapitating a horse. Work in Progress If there’s a single technical issue that kills more deals than any other, it’s how a business recognizes revenue, specifically around work in progress (WIP). Many businesses report revenue on a cash basis, AKA when the money arrives, or on a semi-accrual basis, AKA when they send out a bill. From a QoE perspective, neither approach accurately reflects when the work is actually earned. To do that, we need to look at the earnings schedule which shows the Work in Progress (WIP) and the over/under billings. For industrial, construction, and project-based businesses, getting the revenue in the right period is often the single largest adjustment on the entire QOE report. As you can imagine, it can lead to lots of disagreement and eventually a dead deal. On smaller deals, business owners record revenue differently so the adjustment could be a positive or negative addback to EBITDA. Net Working Capital The second negotiation within a negotiation tends to be working capital. To recap, net working capital is current assets minus current liabilities. In other words, we remove anything long-term, as well as cash-like and debt-like items. While the formula is fairly straightforward, buyers, lenders, and sellers all picture working capital differently. Sellers in particular tend to hate the working capital peg, because it feels like they’re leaving money on the table. Imagine selling a car and then the new owner asks you to gas it up. Now imagine that in today’s economy. Outrageous. When an experienced buyer makes an offer, the EBITDA multiple typically implies a normalized level of net working capital to be left with the business. That’s part of the reason why buyers will pay an extra half turn for a business. What the NWC peg actually does is help get the purchase price right. All that “leftover” cash helps the new buyer mitigate the J-curve: the phenomenon where inventory is a bit depleted, invoices are lost, payables have stacked up, and few other things go awry leaving the new owner without cash. The Ol’ Gift Card Switcheroo Both of these scenarios get much more interesting in the real world. Jackie told me about how she once worked a deal involving a chain of massage franchises that was sitting on roughly half a million dollars in outstanding gift cards. Some of these cards had been issued a decade earlier with no expiration date. On paper, this would be a liability that the new buyer would be on the hook for indefinitely. It wouldn’t necessarily be a cash liability, but the obligation of giving out free massages would fall on the new owner. A buyer will want to treat the cards as unearned revenue: pull redemption data, model out how much of that obligation was realistically still outstanding based on typical redemption curves, and either hold back cash or adjust the purchase price for that amount. The seller, on the other hand, might want to view the gift cards as free marketing rather than a liability. The seller will likely also argue that a future business owner can sell gift cards and not have to do work on 100% of what they sold. Figuring out how much of the cards are realistically redeemable would directly affect the purchase price. All this to say, every deal is different, so make sure you consult your professionals. Now, I’m gonna take a break from writing and look for some old gift cards. It’s A Wrap If You Don’t Prep Jackie once worked with the owner of a specialty vehicle-wrap business serving an unusually high-end clientele, wrapping Bugattis, Bentleys, Lamborghinis, and later a wave of Teslas and Cybertrucks. The owner operated multiple locations, but all of it was kept on one set of books and one bank account. In other words, there was no separation between locations that would eventually need to be valued and sold independently. It took Jackie two years to convince the seller to split the business into separate LLCs, each with its own books, records, and accounts. Doing so allowed each location to be evaluated on its own, which brought the owner one step closer towards franchising the model. Once it was fully separated, there were years of clean, trackable financials that existed for the first time. Two of the franchise locations sold, unlocking value that ran into the millions. I wanted to emphasize this story to show that there are relatively small steps you can take to get your business ready to sell that can yield very large results. A business can’t be accurately valued, let alone sold, if the books aren’t set up right. Whether it’s expenses being tangled up across locations like this example or some other unique scenario, there is so much value in setting things up properly before you go to market. Nowadays, preparing your financials ahead of time is practically a precondition for a deal to exist at all. Buyers are getting more and more educated, and lenders have (finally) joined the party by calling for QoEs. Not to toot my own horn a second time, but I recommend watching the podcast to see how we break down the new changes related to the SBA mandate for QoEs. I’ll give a quick summary below. What Changes Under the SBA Mandate I prefer to be a black-and-white type of person when it comes to takes. So it hurts me to say that I have to use nuance when I talk about the SBA mandate. There is for sure value in forcing transparency on both sides of a transaction. It lets buyers know what they’re taking on, sellers can negotiate based on more accurate numbers, and brokers get added protection against retrades if there is a good sell-side QoE. At the same time, there are some points of contention in the SOP. Some of the language seems to be pushing QoE providers to make commentary on future profit margins and valuation-adjacent judgments. I am not a fan of this, both on a personal level and as a professional. This sort of commentary sits outside what a quality of earnings analysis is supposed to do under AICPA standards. A QoE should explain what the numbers show, not forecast what they’ll become. I have to clarify this distinction all the time with prospective clients (and actual clients) because people conflate my work with a valuation. Just as a side note, drawing lines like these are part of what make financial professionals more AI resistant than what tech bros want to admit. Anybody could prompt a model to smooth over earnings or inflate margins on an AI-generated QoE. What’s stopping them? I can tell you what’s stopping me: my personal ethics and my professional standards. Pro tip, if you are buying a company and the seller has a sellside QoE generated by AI, tell them to provide the prompts they used to generate the report. Chances are they won’t want to for the reasons shared above. Either way, the practical effect of the new mandate is that both sides of a transaction are going to be leaning on quality of earnings work more than they used to. The end result is that buyers, sellers, and brokers are more likely to be on the same page when they sit down at the negotiation table. Just remember, closers get QoEs. Killing the Deal Killers Most of these stories are easy to dismiss as accounting technicalities. In my experience, every deal has some sort of technicality to it. You will run into problems at some point when you try to sell your business. Based on my experience and Jackie’s stories, I can confidently say that you’ll get fewer headaches if you identify those problems before trying to sell. The latest SBA mandate formalizes what the best operators in this space have been saying for years. I was actually drafting letters and articles about this very topic before it was released. I’ve always believed that getting a good quality of earnings report and getting a strong team around you become the difference makers in whether a deal closes or not. I’m glad Uncle Sam agrees with me. Maybe I’ll start campaigning about daylight savings time next. The sun really should never set before 6:00 PM and Michigan needs to be on Central time.