Quality of Earnings

Earnings are a crucial reference point in determining transaction prices negotiated by buyers and sellers of RIA firms. However, reported earnings, even when audited and presented in accordance with Generally Accepted Accounting Principles (GAAP), have limitations. GAAP earnings are backward-looking, reflecting how a business has performed under specific rules in the past. While these historical earnings have their uses, buyers in the RIA industry focus more on the future—what’s visible through the windshield, not the rearview mirror.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.

Apart from a number of headline deals, M&A activity was sidelined for much of 2022 and 2023. But needing to replenish a depleting asset base with quality mineral acreage, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner.  For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace.  And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller.  Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business.  The process can encompass both the financial and operational attributes of the business model.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses or assets to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their assets.  Every dollar affirmed brings value to sellers at the market multiple.  Few investments yield as handsomely and as quickly as a thorough QofE report.  A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction.  The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers.  The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers.  Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process.  A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers.  After core pricing is determined, other features of the transaction, such as working capital, assumption of asset retirement obligations, thresholds for contingent consideration, and other important deal parameters, are established.  These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements.  The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences.  Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters.  The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses.  Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk.  In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter.  A QofE report improves the efficiency of the transaction process for buyers and sellers.  It provides a transparent platform for defining and addressing significant reporting and compliance issues.  There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement.  This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative.  While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal.  Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process.  A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets.  Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms.  It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors.  In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground.  If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena.  Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone.  A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome.  If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.

M&A deal flow was sidelined for much of 2022 and 2023, but the economy’s soft landing, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner. For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace. And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their businesses. Every dollar affirmed brings value to sellers at the market multiple. Few investments yield as handsomely and as quickly as a thorough QofE report. A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction. The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers. The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers. Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process. A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers. After core pricing is determined, other features of the transaction, such as working capital, frameworks for roll-over ownership, thresholds for contingent consideration, and other important deal parameters, are established. These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements. The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences. Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters. The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses. Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk. In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter. A QofE report improves the efficiency of the transaction process for buyers and sellers. It provides a transparent platform for defining and addressing significant reporting and compliance issues. There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement. This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative. While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal. Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process. A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets. Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms. It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors. In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground. If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena. Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone. A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome. If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.WHITEPAPERQuality of Earnings AnalysisDownload Whitepaper For buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.

After sitting on the sidelines for much of 2022 and 2023, the prospect of Fed rate cuts may lure buyers back onto the field in 2024.And when deal activity heats back up, due diligence will be as critical to buyers as ever. For many buyers, a quality of earnings (“QofE”) report is a cornerstone of their broader diligence efforts.For family businesses, an acquisition that goes sour can negatively affect family wealth for decades to come. Obtaining a thorough QofE report as part of deal diligence can help family business directors avoid such a misstep. In this week’s post, we review five reasons family business directors need a QofE report before approving an acquisition.1. Avoid overpaying for earnings that aren’t sustainable.Audited financial statements provide assurance that the past performance of the target company is faithfully represented. However, successful acquirers are focused on the future, not the past. A thorough QofE report helps buyers extract what truly sustainable performance is from the welter of the target’s historical earnings. Paying for historical earnings that don’t materialize in the future is a recipe for sinking returns on invested capital. QofE reports analyze historical earnings for adjustments that convert historical earnings to the pro forma run rate earnings that make an acquisition worthwhile.2. Identify opportunities for cost savings in the target’s expense base.The detailed analysis of cost of sales and operating expenses in a QofE report can uncover opportunities for acquirers to boost margins at the target through cost-saving initiatives. By observing trends in headcount by function, occupancy, and other components of operating expense, buyers can identify redundancies and develop strategies for enhancing post-acquisition cash flow from the target.3. Find revenue synergies with your existing business.A thorough QofE report is not just about expenses. Observing revenue trends by product and business segment, coupled with analysis of customer churn data, can help buyers better understand how the target “fits” with the existing business of the buyer, which can open up strategies for fueling revenue growth in excess of what either company could accomplish on a standalone basis. Armed with a better understanding of opportunities for revenue synergies, buyers can move to the closing table more confident of the upside to be unlocked through the transaction.4. Clarify working capital needs of the target.Incremental working capital investment is the silent killer of transaction return on investment. A thorough QofE report will move beyond the income statement to evaluate seasonal trends in the core components of net working capital. Doing so helps buyers plan adequately for the ongoing working capital requirements they will need to fund out of post-acquisition earnings. Working capital analysis in the QofE report also helps buyers negotiate appropriate working capital targets in the final purchase agreement.5. Assess capital expenditure needs at the target.Not every dollar of EBITDA is equal. EBITDA multiples are a function of risk, growth, and capital intensity. Buyers cannot afford to overlook capital intensity when evaluating targets. A thorough QofE report examines historical trends in capital expenditures and fixed asset turnover to help buyers better discern the prospective capital expenditure needs of the target and how those needs influence the transaction price and prospective returns. For family businesses contemplating an acquisition, the stakes are high. You can’t eliminate risk from an M&A transaction but obtaining a thorough QofE report on the target can help directors avoid mistakes and increase the odds of a successful deal. If you are considering an acquisition in 2024, give one of our senior professionals a call to discuss how our QofE team can generate Insights That Matter for your diligence team.WHITEPAPERQuality of Earnings AnalysisDownload WhitepaperFor buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.

What Buyers and Sellers Need to Know About Quality of Earnings ReportsFor buyers and sellers, the stakes in a transaction are high. You only get one chance to do it right.Commissioning a quality of earnings report is an essential step in getting the transaction right.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.Leverage the experience of our QofE team to generate Insights That Matter in support of your next transaction.

This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Energy Valuation Insights blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Family Business Director blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

As we’ve been writing in recent blog posts, consolidation efforts in the RIA space are facing multiple headwinds. Among them, market conditions and inflation are motivating buyers to scrutinize profit estimates more than ever. In that light, we thought our readers would appreciate this guest post by our colleague, Jay D. Wilson, Jr., CFA, ASA, CBA, who works with banks and FinTechs. We’re getting more requests for QoE assessments from both the buy-side and sell-side (the latter wanting to buttress their CIMs).Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

As we’ve been writing in recent blog posts, consolidation efforts in the RIA space are facing multiple headwinds.  Among them, market conditions and inflation are motivating buyers to scrutinize profit estimates more than ever.  In that light, we thought our readers would appreciate this guest post by our colleague, Jay D. Wilson, Jr., CFA, ASA, CBA, who works with banks and FinTechs. We’re getting more requests for QoE assessments from both the buy-side and sell-side (the latter wanting to buttress their CIMs).Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

As we find ourselves at the end of the decade, many pundits are considering what sector will be most heavily influenced by the disruptive impact of technology in the 2020s. Financial services and the potential impact of FinTech is often top of mind in those discussions. As I consider the potential impact of FinTech in the coming decade, I am reminded of the Mark Twain quote that “History doesn’t repeat itself but it often rhymes.”A historical example of technological progress that comes to mind for me is the combine, a machine designed to efficiently harvest a variety of grain crops. The combine derived its name from being able to combine a number of steps in the harvesting process. Combines were one of the most economically important innovations as they saved a tremendous amount of time and significantly reduced the amount of the population that was engaged in agriculture while still allowing a growing population to be fed adequately. For perspective, the impact on American society from the combine’s invention was tremendous as roughly half of the U.S. population was involved in agriculture in the 1850s and today that number stands at less than 1%.As I ponder the parallels between the combine’s historical impact and FinTech’s potential, I consider that our now service based economy is dependent upon financial services, and FinTech offers the potential to radically change the landscape. From my perspective, the coming “combine” for financial services will be not from one source or solution, but from a wide range of FinTech companies and traditional financial institutions that are enhancing efficiency and lowering costs across a wide range of financial services (payments, lending, deposit gathering, wealth management, and insurance). While this can be viewed as a negative by some traditional incumbents in the space, it may be a saving grace as we start the decade with the lingering effects of a prolonged historically low and difficult interest rate environment, and many traditional players are still laden with their margin dependent revenue streams and higher cost, inefficient legacy systems. Similar to the farmers adopting higher tech planting and harvesting methods through innovations like the combine, traditional incumbents like bankers, RIAs, and insurance companies will have to determine how to selectively build, partner, or acquire FinTech talent and companies to enhance their profitability and efficiency. Private equity and venture capital investors will also continue to be attracted to the FinTech sector given its potential.As the years in the 2020s march on, FinTech acquirers and traditional incumbents face a daunting task to evaluate the FinTech sector. Reports vary but generally indicate that over 10,000 FinTechs have sprouted up across the globe in the last decade and separating the highly valued, high potential business models (i.e, the wheat) from the lower valued, low potential ones (i.e., the chaff) will be challenging. Factor in the complicated nature of the regulatory/compliance overlay and investors, acquirers, and traditional incumbents face the daunting task of analyzing the FinTech sector and the companies within it.As a solution to this potential problem, the efficient operations and historical lessons learned in the agricultural sector from the combine may again provide insights for buyers of FinTech companies to learn from. For example, the major professional sports leagues in the U.S. all have events called combines where they put prospective players through drills and tests to more accurately assess their potential. In these situations, the team is ultimately the buyer or investor and the player is the seller. Pro scouts are most interested in trying to project how that player might perform in the future for their team. While a player may have strong statistics in college, this may not translate to their future performance at the next level so it’s important to dig deeper and analyze more thoroughly. For the casual fan and the players themselves, it can be frustrating to see a productive college player go undrafted while less productive players go highly drafted because of their stronger performance at the combine.While not quite as highly covered by the fans and media, a similar due diligence and analysis process should take place when acquirers examine a FinTech acquisition target. This due diligence process can be particularly important in a sector like FinTech where the historical financial statements may provide little insight into future growth and earnings potential for the underlying company. One way that acquirers are able to better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE). In this article, we give a general overview of what a QoE is as well as some important factors to consider.What is a Quality of Earnings Study? A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer in order to assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors. Ongoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long term growth can be expected. This estimate of earning power typically considers trying to assess the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-back; (2) Non-recurring items; (3) Pro-forma adjustments/synergiesCustomer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysisBusiness and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring These areas are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth technology companies where the analysis and valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the some of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers perception for the company and its products. This article discusses a number of considerations that buyers may want to assess when performing due diligence on a potential FinTech target. While the ultimate goal is to derive a sound analysis of the target’s earning power and potential, there can be a number of different avenues to focus on, and the QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers. Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers. Leveraging our valuation and advisory experience, our quality of earnings analyses identify and focus on the cash flow, growth, and risk factors that impact value. Collaborating with clients, our senior staff identifies the most important areas for analysis, allowing us to provide cost-effective support and deliver qualified, objective, and supportable findings. Our goal is to understand the drivers of historical performance, unit economics of the target, and the key risk and growth factors supporting future expectations. Our methods and experience provide our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows. Our methodologies and procedures are standard practices executed by some of the most experienced analysts in the FinTech industry. Our desire is to provide clients with timely and actionable information to assist in capital budgeting decisions. Combined with our industry expertise, risk assessment, and balanced return focus, our due diligence and deal advisory services are uniquely positioned to provide focused and valued information on potential targets. Originally published in Mercer Capital's Value Focus: FinTech Industry Newsletter,  Year-End 2019.