Preparing for a Transaction: The Quality of Earnings Report
Founders often ask what the most critical preparation steps are prior to launching a process. There are obviously many important pre-process items that are important to get in order but if we had to pick one as our strongest recommendation of all it would be engaging an accounting firm to prepare a Quality of Earnings report or “QoE” for short. Below we discuss what it is and why it matters so much.
What is a QoE Anyway?
A QoE is a financial report prepared by a third-party accounting firm that validates the sustainability and accuracy of a company’s earnings. How is it prepared and what is the deliverable? The accounting firm will reconcile your general ledger data with your monthly financials ensuring that they are GAAP-compliant. The QoE will also usually include a build to non-GAAP profitability metrics such as “Adjusted EBITDA” such that investors can ascertain the true cash flow margin of the business normalized for non-recurring expenses. For our clients we also recommend having the accounting firm prepare a revenue by customer file on a monthly basis that ties back to the monthly P&L as investors will use revenue by customer data to analyze various SaaS KPIs. Many QoE reports will also include brief commentary on various financial matters such as a company’s revenue recognition policy, typical customer contract frameworks, any seasonality in the business etc.
Why Does It Matter So Much?
Surprises (Especially as it Relates to the Financials) Are Bad
When investors begin to assess your business unsurprisingly the financials are the most important aspect. And so, the last thing you want during a process is investors discovering material financial misstatements that can alter their fundamental view of the business. This might seem obvious, but founders often gloss over what “material” can mean. You told investors gross margin was 75% but it’s actually 65% because customer success SG&A was incorrectly classified? That could very well lead to a big re-trade during exclusivity or even an investor cancelling their offer altogether. For SaaS businesses in particular relatively modest seeming financial misstatements can lead to massive swings in valuation estimates because so much of the value of the business is predicated on extrapolating future cash flows which are very sensitive to minor changes in today’s operating profile. ARR in particular is vitally important to get right as this is the primary valuation metric that SaaS investors rely upon. Maxwell Locke & Ritter has an excellent blog post here that delves into this in more detail. Lastly, it should be noted that the QoE also allows you to proactively identify and mitigate against any unflattering financial anomalies in the business vs. being back on your heels during the process.
Demonstrates an Organized Commitment to Transact (and so Increases Investor Interest)
When a company prepares a QoE as part of transaction prep investors infer it as a signal that the company is organized and strongly intending to transact. Why does this matter so much? Investors are assessing countless opportunities each year and so one important filter is the following question: is this prospect committed to transacting and have they demonstrated commitment by investing the time and resources to properly prep? A company that appears to be ambivalent about actually transacting and/or disorganized could end being a painful time suck and so investors can be reticient about engaging with these companies. Performing a QoE prior to launch is sending a clear message to the market that you are well worth their time.
Time Kills Deals
Preparing a QoE prior to launching a transaction almost always greatly expedites the transaction timeline because the investor has clean financial data to work with and so doesn’t need to spend as much time on financial diligence. During diligence investors will hire their own 3rd party accounting firm to perform a second QoE but having your QoE at the ready provides a running start. Preparing your own QoE can cut weeks off of the exclusivity period once you sign a letter of intent. Remember - time kills deals so you should seize any opportunity you have to streamline your transaction timeline.
Maximizes Valuation
Investors tend to bid higher for businesses when they know the data is reliable. Think about buying a house. All other things equal, would you bid a bit higher if there was a reliable inspection report available so you had an accurate view of the financial exposure? Investing into a business is similar. Beyond that, there’s the protection against “underselling” your financials. Imagine that you’re in market and receiving bids. You sign an offer to enter exclusivity and the investor performs a QoE and discovers your financials are actually better off than you expected - great news, right? Sort of. Obviously, you avoided a re-trade but we can almost guarantee they won’t be boosting their offer either. You’ll really wish you had done your own QoE at this point as you could be leaving millions of dollars on the table. Consider the QoE insurance against accidentally underselling your financials.
Leverage During Diligence
Financial diligence from investors can be extremely taxing to your team. Numerous questions about granular data with the expectation of rapid responses. How does the QoE factor in here? Many teams find their QoE provider to be very valuable in assisting with financial diligence as the accountants will obviously be intimately familiar with your financials after combing through your financials at the general ledger level. Your team can end up being stretched very thin (again, time kills deals) during financial diligence without being augmented by an accounting firm.
Common Pushbacks
Founders understandably are sometimes skeptical of the value of a QoE. Below are some of the common responses / questions we get when recommended they engage an accounting firm to perform one.
I Already Have Audited Annual Financial Statements
We get it. You already pay an accounting firm to audit your annual financial statements for tax purposes. We cannot stress this enough - there’s a massive difference between audited annual financials and QoE-quality monthly financials. These are very much not the same thing and should not be treated as such. Investors will need accurate financials down to a monthly basis.
It Seems Expensive
Understandably there can be sticker shock when a founder hears what a QoE costs which is generally $80K to $120K depending on the firm, scope, and cleanliness of the data. We always emphasize that it pays for itself and more. Think about a business that is $5M of ARR paying $100,000 for a QoE. All it takes for the QoE to pay for itself is for the final offer to come in at 0.02x of ARR higher. 8.02x vs. 8.00x and the QoE paid for itself. Again, investors tend to feel more comfortable leaning in on valuation during bid submission if they know the data is reliable.
Ok Fine I’ll do a QoE, But I’ll Use My Own Accountant
We strongly recommend engaging an accounting firm that checks two boxes: a) highly credible to the investor community and b) extensive experience in B2B SaaS specifically. Why (a)? Because you want investors to have conviction in the data when they bid and want whoever you enter exclusivity with to minimize their own QoE workstreams by relying heavily on your data. Why (b)? Because a SaaS P&L has various nuances (e.g. ASC 606, how to categorize COGS vs. SG&A, bookings to billings to revenue build) that can be difficult for a generalist QoE provider to be experts in. If your accounting firm checks both boxes then great, they can certainly work as the QoE provider. That said, we find that many accounting firms founders use don’t, and so we are more than happy to connect with you some that do.
Conclusion
Hopefully this post helped convince you that a pre-process QoE is well worth it. As mentioned above, we are happy to introduce you to the various firms that could be a good fit to handle yours so you can get a detailed understanding of the scope of work and cost.
