Someday you will sell your firm. After all, none of us can run our firms from the afterlife. When your time to exit comes, you will need to know what your firm is worth. The tool often used to calculate a purchase price is called a QOE, or the quality of earnings report. On this episode, QOE expert Elliott Holland, Founder & CEO at Guardian Due Diligence, will help founders understand what a QOE is, when it is needed, who creates one, how it gets used, and why founders need to get familiar with it.
TRANSCRIPT
Greg Alexander [00:00:15] Welcome to the ProServ podcast with Collective 54, a podcast for leaders of thriving boutique professional services firms. For those who are not familiar with us, Collective 54 is the first mastermind community dedicated to the needs of boutique pro firms. My name’s Greg Alexander. I’m the founder and I’ll be your host today. On this episode, we’re going to talk about a tool that you’ll use someday when you’re trying to sell your firm. It’s called the q0e, which stands for Quality of Earnings. And we have a true expert who does this for a living. His name is Elliot Holland. He’s also a member of Collective 54. So, Elliot, it’s great to see you. Would you introduce yourself to the audience, please?
Elliot Holland [00:01:02] Absolutely. Great to be here. I’m Elliot Cowan, Harvard Business School, former private equity professional. And now I run a business that helps entrepreneurial business buyers vet acquisition targets using an audit like service called Equality of Earnings that we’ll dive into deeper here in a second. But essentially, I try to help entrepreneurs and keep them away from losing money in very happy situations where there’s huge motivations for people to misstate the truth.
Greg Alexander [00:01:34] Okay, sounds great. So let’s start at the very top. A lot of our members are first time founders. They’ve never been through an exit. Someday they all know that they will sell their firm someday because unfortunately, we can’t run our firms from the afterlife. And since they’ve never been through that process before, this term quote, equality of earnings, they don’t even know what it is. So can you just give us a basic definition?
Elliot Holland [00:02:01] Sure it is an audit service. So for a public company, what they do each year is an audit which looks through extensive information and makes public stock accessible to everyone. What the quality of earnings is is a mini version of that specifically used for buyers of companies to assess the financials of private companies. Anyone on here who owns their own business knows how difficult tech firms can be and how difficult setting up your financials and keeping them straight can be. So imagine a buyer coming into that environment, and the quality of earnings is a tool that can standardize the business financials of any business owner into a package that any investor can consume and make an acquisition decision. But to sum it all up, it is very similar to an audit specifically for the you are buying a company.
Greg Alexander [00:02:54] Okay, very good. And when as a founder, am I most likely to need to use or build a q. O. E.
Elliot Holland [00:03:05] Sure. So the two times that you need to use it, one, if you are looking to grow by acquisition, you see a target company that’s in a market you want to get into. You see somebody you know who’s selling. When you decide to buy their business before you execute that transaction. You want to hire someone to do a quality of earnings. Why? Because there’s. Huge variability in financials relative to what’s presented often times and you don’t want to get had. So that’s one. The second time is if you are approached to sell your business or you decide to take your business to market. Greg talks about this all the time. You’re getting an investment banker or business broker. I would highly encourage you at that moment to get a quality of earnings as well. Here’s why you want to have your own point of view of your numbers before a bunch of picky buyers come in and start hiring the same providers for their benefit. And the pain for an owner who does their own quality of earnings. The pain during the selling process is drastically reduced if they have their own quality of earnings. So those are the two times people should think about quality earnings.
Greg Alexander [00:04:20] Okay. And it sounds intimidating. How long does it take? And, you know, if I’m a first time founder who’s never done it before. Can I pull it off?
Elliot Holland [00:04:32] So it’s easy peasy and I’m smiling only because I’m such an entrepreneurial advocate on both sides, buyers and sellers. So essentially, your bookkeeper, your CPA, and the person sitting in my seat as the equality of earnings company lead or accounting lead do 95% of the work. So to make the process super simple and easy to digest, it’s essentially three steps. As an owner who’s going through one, they send you a list of information. If they’re good at small business kilos, their list is 40 to 60 items. Of those items, two thirds will be handled by your bookkeeper or CPA, and the other third will be handled by maybe a half hour to a 45 minute conversation on the phone. So you get a list, you give it to people to fill it out. You get on a phone call for a half hour to 45 minutes to answer business, marketing certain questions about the business. And then you wait for 3 to 4 weeks for the work to be done. Now, there may be questions in between on step three. Those questions oftentimes are not all that detailed. And oftentimes your controller or your CPA can answer them. So for a owner, it may encumber. Let’s just say it takes 3 hours to sort of get your troops going on the day to another hour for a call. You invest between one and 4 hours in this process. And I’ll also say a lot of us as private business owners have done some interesting things in our financials. You should not be scared of sharing those things because the providers who do this are so used to handling it. Just just be honest. Get it all out and it’ll be done in four weeks.
Greg Alexander [00:06:15] So let’s say I’m a founder and I have a successful firm, so I potentially have an inflated opinion of myself and I think I can do this on my own or I can pencil whip it just by, you know, exploiting my QuickBooks file. And that should be good enough. Am I nuts?
Elliot Holland [00:06:34] Yes, I’d. I’d respectfully laugh at you.
Greg Alexander [00:06:37] Okay.
Elliot Holland [00:06:39] Here’s why. There’s too much money. Okay, So the people I’m speaking to are people who have businesses that are likely going to sell for 1000000 to 40 or $50 million. Right. They’re going to be sold at a lot of cash flow or EBITA. We won’t get into it, but just a multiple a profit to keep it simple. So when you say, hey, I’m going to go cheap and easy and homegrown and I’m going to export my QuickBooks and it’s accounting crap, they don’t care. My business is worth whatever. What you don’t realize is I’m going to be the one on the other side working for the buyer, picking your financials apart at in my 10th degree of detail and then telling you think about things about your financials that are accounting oriented but will affect the price that you won’t understand yet because you have not gone through the process for your own benefit. So let’s just walk you through an example. When sellers don’t do the quality of earnings before, when founders don’t do it, before you get into situations where accounting things, where something is is presented in one way is taken as a big deal, when it’s really a small deal and you’re getting a multiple of profit. So like a 10% difference. So if your profit is a million bucks, if the buyer can go through your front end and shows and show you that your true profit when all the accounting stuff is handled, is even 10% off, right on a4x deal, that $100,000 could be $400,000 worth of lost value. So by, you know, avoiding 22 for a quality of earnings, you just lost 400 K.
Greg Alexander [00:08:15] Yep.
Elliot Holland [00:08:17] That’s before I even talk about you have your own financials. You go through less pain through the whole process because people don’t have to ask as many questions.
Greg Alexander [00:08:25] Yep. Now, so far we’ve been talking about if I, the founder of my firm, is planning on selling my firm, we haven’t talked about the counterparty on the other side of the desk. The firm was thinking about buying my firm and their due diligence process. So it’s likely it’s likely especially, you know, professional acquirers, they’re going to hire their own firm to do their own QE. So there’s really two of them being done. Is that correct?
Elliot Holland [00:08:52] It depends on the size of the business and the buyer. So I would say in the deals that I’ve seen and I focus on deals sort of $2 million to 25, $35 million is where I live. If the seller does the quality of earnings typically be the buyer who comes in will either assess the quality of earnings and the quality of the firm that’s done it, and they may just get their accountants to review it. That’s most often the case because people don’t want to pay twice for the quality of earnings or if there is a second quality of earnings, it’s a sanity check, not a product, a logical exam. So if you’re going to have somebody go through your financials at that level, you want to be the one paying them. You don’t want somebody that somebody else paid doing that exam.
Greg Alexander [00:09:38] Yeah. Okay. Now, the the person who’s buying the firm, the acquirer, they’re going to take this QC and they’re going to do what with it?
Elliot Holland [00:09:48] So let’s just talk about $1,000,000 Eboni business, which is just cash flow, a profit and a four times deal. So you’re selling your business for $4 million. The buyer will come in and do a quality of earnings and say, I’m going to multiply whatever the evil that this found in my quality of earnings by four. So they’re going to go in and look at your income statement, your balance sheet, your working capital, your bank statements, your taxes. Running through that four week analysis. And then they’re going to come back and say, hey, based on our accounting team, your actual EBIT is $900,000. And so now they’re going to say $900,000 times four is 3.6 million, not 4 million. And so our price now just got adjusted, 400 K It also happens in the other way. So they may find that the profit is higher than what was presented, but they’re not in a position to tell you that. So what would buyers do with the quality of earnings is use it as the basis for the EBIT number that they multiply by to get to the value.
Greg Alexander [00:10:52] Okay. And do they share it with the bank if they’re going to fund it that way?
Elliot Holland [00:10:58] Oftentimes, sometimes not. But you should assume that the quality bearings will go to all interested investors, even though sometimes it doesn’t. Depending on the buyer, if they have good relationship with their banks, depending on the size of the deal. Also, as you get out of when you get out of sort of two, three, 4 million and get above that, then the answer is absolutely yes.
Greg Alexander [00:11:22] Correct? Yep. Okay. One last question for you on this. This is a personal pet peeve of mine. Sometimes our members get advice from their broker, the M&A adviser or the investment banker that they got to spend a fortune on acuity and hire a big name firm like a p.w see, which I think is crazy for our members, because those can be very expensive and they don’t need to spend that kind of money because our members businesses, relatively speaking, are easy in simple businesses to do this. So, Eliot, what would you say to that advice?
Elliot Holland [00:11:58] So I don’t think the big firms like Peter them you see, do strong in meeting business quality of earnings well at all. So my point of view is not only will you overpay for it, but you will get the debt. Not that it would be the C, but the DTI, the kids coming straight out of college. The partner who doesn’t want to spend a lot of time on it. You’re not an important entity in their ecosystem of a lot of private equity firms and multiple buyers. So you’re going to get the last bit of energy they have. And when a transaction is this big for you as a founder, it matters that you get the A-Team and a quality sort of driven firm. So I would highly encourage you to look for regional firms that are more that are priced more cost reasonable or due diligence firms like mine that focus on just quality of earnings that have great reputations in the marketplace. You don’t need a quarter million dollar, $100,000 quality of earnings. You need one that solid by a reputable firm. Yep.
Greg Alexander [00:13:00] And not to put you on the spot here, but I know you do this for a living. Give me a range. What’s a ballpark budget figure for something like this?
Elliot Holland [00:13:08] Sure. So 20 to $60000 should cover it for companies that are selling for 1 million to. 25, $30 million. When you get above that, you may ratchet that upper end of the range up a bit, but that is a very reasonable range. You get your quality of earnings done.
Greg Alexander [00:13:26] Okay, Fantastic. Well, listen, we’re out of time. But Elliot, you and I have recently gotten to know each other. You’re a relatively new member. I’m so glad that you’re in the community. Your energy and enthusiasm is infectious, and your area of expertise, as we just learned today, is desperately needed for our community. So on behalf of all the other members, I appreciate you being part of Collective 54 and in particular for making the deposit in the Collective Knowledge Bank today. Thanks a bunch.
Elliot Holland [00:13:52] So excited to be here. Thank you for having me. And I’m glad to be in collective 54 as well.
Greg Alexander [00:13:58] All right, very good. So let me give the audience members a couple of call to action. So let’s say you’re not a member, but you’re thinking about it because you want to meet really interesting people like Elliot and learn about these tools like quality of earnings. Go to collective 54 dot com, fill out the contact us form, and one of our representatives will talk to you about being a member. If you if you are not ready quite yet to be a member and you want to educate yourself further, subscribe to collective 50 for insights and you going to get three things on Monday. You’re going to get a blog, on Wednesday, you’re going to get a podcast, and on Friday are you going to get the chart of the week? And that’s a good way for you to learn more about this if you are a member listening to this, my call to action is a little bit more precise. So the first thing I want you to do in the new Boutique Companion course, there is a Kuo e template I really want to emphasize. It’s an introductory basic template that will get you familiar with kind of what something like this looks like. Of course, to execute it, you’re going to need a professional like Elliott. And then also if you’re not quite ready for a cue because you’re not ready to sell your firm, but you’re really interested in what your firm might be worth on the website. Under resources, we have a tool called the Firm Estimate here. That’s a really fun tool. Takes about 15 minutes to fill out your answer ten questions. It gives you a ballpark range as to what your firm is worth. I really want to emphasize here a ballpark range. It’s not a precise valuation, but check that out if you’re interested. Okay. So that’s the end of today’s show. Thanks for listening. Thanks for being here. We really look forward to Elliott’s private Q&A with the members on one of our upcoming Friday member sessions. But until then, we’ll talk to you on the next one.