With a sell-side quality of earnings engagement, the aim is to identify the actual cash flows of a business over a period of time so that buyers can make a meaningful decision around what they're dealing with, says Gray, Gray & Gray LLP Partner Derrick Rebello.
In a professional process with audited financial statements, the firm is brought in to do a quality of earnings with the intention of making the process go smooth and not allow a lot of time to go by while uncovering any issues that could disrupt a deal. They're looking at recurring cash flows, what's happening with reserves, looking at taxes and more. Then there are not-so-professional processes.
"We come in and we're trying to make lemonade out of lemons," he says. "We have perhaps a company that hasn't really thought about getting their business ready for sale — has been a lifestyle business and has done things in the background maybe not in accordance with GAAP, maybe on a cash basis, maybe just QuickBooks — and trying to get in there and to try to make their numbers so that you can have a meaningful sales process."
In those circumstances, there can be many issues, such as an understatement of inventory, significant tax issues at the state and local levels, and payroll issues. It can be a lot to clean up.
"If you're going to sell your house, you'd paint the fence, you'd fix things," Rebello says. "And that's what we try to do. We try to present the numbers in the best light because what happens is if you don't have your house in order, both from an accounting and tax standpoint, it's just going to take a lot of time. You're not going to get what you're supposed to get for your business."
When McCarthy Capital Partner Bob Emmert is in the middle of legal and accounting diligence and things start to bog down a little bit because the seller is not really prepared — for instance, the management team isn't aware of contracts that need consent for assignment, they haven't invested in the accounting system, the cash flows they've represented are really cash accounting not GAAP accounting — it causes him to have concern about management and whether it makes sense to do the deal at all.
"The analogy I use is if you're selling your house and the house is filled with trash and the paint is peeling off the walls, and the management team hasn't taken the time to fix that before they bring it to market, it makes me worry about all the things I can't see," Emmert says.
While a few issues discovered during diligence could be addressed, multiple issues could mean the firm walks away from the deal rather than reprice it. That's in part because firms are often looking to partner with, rather than replace, management. So, finding many issues in a process that cause a deal to get hung up often means losing confidence in the folks that would become a partner.
Rebello and Emmert spoke at the Boston Smart Business Dealmakers Conference about the sell-side issues that give them pause in diligence. Hit play to catch that excerpt of the discussion.